Recognize the Signs of an Asset Bubble

An asset bubble is when the price of an asset, such as housing, stocks or ​gold, become over-inflated. Prices rise quickly over a short period. They are not supported by an underlying demand for the product itself. It’s a bubble when investors bid up the price beyond any real sustainable value. These price spikes often occur when investors all flock to a particular asset class, such as the stock market, real estate or commodities. Such a bubble is also called asset inflation.

Three Causes

Low interest rates are the most frequent cause of an asset bubble. They create an over-expansion of the money supply. Hence, investors can borrow cheaply but cannot receive a good return on their bonds. So they look for another asset class.

The second biggest cause is demand-pull inflation. That’s when an asset class suddenly becomes popular. As asset prices rise, everyone wants to get in on the profits. But the consumer price index does not always accurately capture this form of inflation. So policy-makers overlook it.

Third, a supply shortage will aggravate an asset bubble. That’s when investors think that there is not enough of the asset to go around. They panic and start buying more before it runs out.

How to Protect Yourself from an Asset Bubble

The hallmark of an asset bubble is irrational exuberance. Almost everyone is buying that asset. For a long time, buying that asset seems profitable. Often the price just keeps going up for years.

The problem is that it is tough to time a bubble. As a result, most financial planners recommend a well-diversified portfolio of investments. Diversification means a balanced mix of stocks, bonds, commodities and even equity in your home. Revisit your asset allocation over time to make sure that it is still balanced. If there is an asset bubble in gold or even housing, it will drive up the percentage you have in that asset class. That’s the time to sell.

Work with a qualified financial planner, and you won’t get caught up in irrational exuberance and fall prey to an asset bubble.

 

 

 

SOURCE: THE BALANCE



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