Spot these three signs and you could avoid future bubbles.
Bubbles and crashes are woven into the very fabric of markets. They're the signposts we use to chart investing history. Can we spot them in advance? ABC says you can.
'A' is for Arrogance
"It's different this time". If prophets are telling you that normal rules don't apply, and profits are seen as simple to obtain, then trouble is brewing. Remember dot-com?
'B' is for Boom
When prices rise fast enough to make headlines outside the financial pages, then watch out. People who normally skip straight from the TV listings to the sport get interested in shares, in overseas property development, or in anything that looks like easy money. How much has my neighbour made on his share trading? Why haven't I made a killing? Buy!
And 'C' is for Credit
History shows us that, whenever a bubble starts to boil, there'll always be cheap and readily available money heating the cauldron somewhere.
The ABC of Tulips
Take the famous 'Tulip Bubble'. It wouldn't be fair to call the Dutch 'arrogant' in 1637, but they certainly weren't in a normal state of mind; a bubonic plague outbreak had killed one seventh of Amsterdam's population by 1636. No wonder speculators were a little more reckless than usual.
The 'boom' element was certainly there: prices for sought-after bulbs hit ten times the annual pay of a skilled worker.
And 'credit'? You bet. The first documented futures markets in Europe sprang from Dutch taverns where anybody, Prince or Pauper, could take a leveraged position on tulips. Derivatives are just like debt in that they can be used to 'buy' stuff you can't actually afford. Big wins, and big losses, are part of the territory.
Incidentally, part of the Dutch government's response to the bubble was to ban short selling… sound familiar?
The Great Crash
Fast forward to 1929. The Great Crash on Wall Street needs no introduction.
'Arrogance' was flowing like champagne on bonus day. Irving Fisher's famous line says it all: "Stock prices have reached what looks like a permanently high plateau." But Fisher wasn't alone. "We will not have any more crashes in our time" (John Maynard Keynes, 1927) and "There will be no interruption of our permanent prosperity" (Myron Forbes, 1928) are just two more gems from the roaring '20s. They were begging for it, weren't they?
'Boom' is beyond doubt. The Dow Jones grew like bamboo, going up fivefold from 1923 to 1929. But it wasn't Miracle-Gro ® being poured onto shares; it was the usual suspect: credit.
Trading on margin was a specialist activity in 1923. By the peak of the boom the brokers were practically lending to domestic cats in exchange for a paw print and a promise. A massive $8.5 billion was on loan to small, retail investors in August 1929. A,B, and C were all present and correct. The Great Crash, as we know, hurt like hell.
Propped up property
Finally, let's look closer to home. Hands up if you heard a big-mouthed Brit boasting about the high price of his house between 2002 and 2007. There was a 'boom' alright: average house prices went up by 90% over the period. The 'arrogance' was palpable, too. TV shows were telling us that anyone without a ten property buy-to-let portfolio was a bit of a loser.
How did we pay for it all? Credit, of course! Mortgages based on only three times salary were passé by 2005; antiquated concepts like 'deposits' and 'equity' became about as fashionable as flares. Fancy a 125% mortgage based on eight times your income? Sign here, Sir.
The only difference between Wall Street, 1929 and Acacia Avenue, 2008 is that house prices crash over years instead of days.
How can you dodge bubbles?
What do all these cases of ABC have in common? Hindsight! It's easy for us to laugh at the mugs who bought tulips, the inflated Dow Jones, or an off-plan residential flat in Manchester at just the wrong time.
In truth, bubbles are like bullets: you won't hear the one that hits you. So, knowing that crashes are a fact of life, what can investors do?
Three things: firstly, be realistic about the risks you can handle. Never overexpose your portfolio to risk out of sheer greed. Ask yourself how you'd feel, and what you would do, if the FTSE suddenly lost 40%. If the scenario makes you shiver, then seek out some lower risk assets. Don't kid yourself that you can call the top and jump off the ride in time. You might not make it.
Secondly, don't be too afraid. Crashes make good stories, but a sensible long-term investor will always come out ahead of the fleet-footed market timer.
Thirdly, use your secret weapon: the luxury of time. If you're really worried about investing a lump sum today, then drip feed it into the market over months or years. A crash should then leave you grinning as you hoover up the bargains.
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