How to maneuver your way through a bubble
In financial parlance, a bubble occurs when there is a rapid escalation of market value of assets without any corresponding increase in valuations of underlying factors. The price rise is exponential, in excess of the asset’s underlying value and is generally, driven by raw speculation.
In its annual report for FY 21, the Reserve Bank of India raised the red flag of a stock market bubble. The apex bank noted that India’s equity prices had touched record highs, with the Sensex crossing the 50,000 mark on January 21, 2021 to touch a peak of 52,154 on February 15. This represents a 100.7 per cent increase from the slump just before beginning of the nationwide lockdown (since March 23, 2020) and a 68 per cent rise over the year 2020-21.
“This order of asset price inflation in the context of the estimated 8 per cent contraction in GDP in 2020-21 poses the risk of a bubble,” the RBI said. Anyone who has been keeping an eye on the domestic stock market in the past few months will concur that the courses have been performing eerily well – in stark contrast to the economic disruption unleashed by the second wave of the coronavirus pandemic. In fact, according to the latest estimates of economic growth released by the Indian government, for the last financial year that ended in March 2021, India’s GDP has contracted by 7.3 percent.
Bubbles can have the potential to change the course of your finances. In financial parlance, a bubble occurs when there is a rapid escalation of market value of assets without any corresponding increase in valuations of underlying factors. The price rise is exponential and in excess of the asset’s underlying value and is generally driven by raw speculation. Eventually the prices plateau which is followed by a sharp decrease or contraction in value and this is commonly referred to as a “crash” or “ bubble burst.”
Bubbles are typically driven by change in investor behaviour – speculation reigns supreme in the minds of the investors and the price of an asset accelerates with many people willing to pay more and more for it. This leads to the genesis of a self-perpetuating cycle fueled by speculation and contagious enthusiasm among investors and traders where people flock to buy an asset attracted by its increasing prices, driving the price even higher and making more people desirous of buying it.
It is important to remember that it is only in hindsight that a bubble can be spotted when it has burst. However, experts believe that there is a proverbial method to the madness. American economist Hyman Minsky identified in his book Stabilizing an Unstable Economy (1986) that bubbles generally go through five stages. Understanding the five stages can help investors be better prepared to navigate these bubbles.
Displacement: This is the first stage that marks a major change or a succession of changes that impacts investor sentiment. The shift generally entails an important event or a new development or innovation that brings forth a change in the way investors perceive an asset.
Boom: Following displacement, prices rise slowly but as more participants enter the market and the asset in question starts grabbing eyeballs, the speculation effect snowballs and price rise accelerate.
Euphoria: There is euphoria, there is excitement, there is headiness, there is fervor and there is no rational justification in this phase. In this phase, the surge in valuation is colossal and there are too many people itching to jump on to the bandwagon. This makes it easy for investors to believe in the mirage that should they wish to sell, there will easily find someone who would be willing to pay more. The conviction that it’s a once-in-a-lifetime-opportunity takes root and investors readily invest sums disproportionately higher than their risk appetites.
Profit-taking: Some investors who are able to spot the storm on the horizon start selling off to lock in gains at this stage. Prices having reached Utopian levels, the bubble burst becomes imminent and investors who are receptive to the signs can reap profits.
Panic: The bubble has been perforated and the free-fall in valuations has already started because as opposed to the previous phases where fascination hung heavy, the atmosphere becomes riddled by desperation to sell. Here also, the plunge in prices triggers a loop – as prices fall, more people start selling and this causes a further dip in prices.
How to invest during a bubble?
While it is impossible to insulate yourself completely from volatility since bubbles are a recurring phenomena and you may swept into on unintentionally, keeping the FOMO at bay plays a crucial role in helping you stay on course during bubbles. To avoid getting sucked into a bubble that will eventually burst, it is important to gauge your reasons for investing in the hyped asset class before you do so. Ask yourself whether the move is driven by a desire to follow the herd because if that is the case your expectations and calculations regarding returns may be heavily coloured by the prevailing speculation. This can make you take unnecessary risks and cause heavy losses later when the bubble has been pricked.
Another important strategy is to not hold off on existing investment plans while anticipating the bubble burst. Timing the market is a futile exercise and the best ways to safeguard your investment from wild fluctuations are staggered investments over time and SIPs in a mutual fund spread with low correlation and suitable for your risk-taking abilities. In the long run, SIP investments in mutual funds can iron out the creases left by bubbles thanks to the benefit of rupee-cost averaging. Hence mutual funds, especially long term ones are a safer bet compared to stocks when a bubble is underway.
• Long term investments in large cap mutual funds can help you weather a bubble.
• Keep the focus on investing according to your goals. This will reduce your inclination to join the party.
• It is important to review and re-balance your portfolio if there is a rise in the valuations of various asset classes during a bubble. This will reduce the chances of a bloodbath when the burst occurs.
• In the long run, SIP investments in mutual funds can iron out the creases left by bubbles thanks to the benefit of rupee-cost averaging. Hence mutual funds, especially long term ones are a safer bet.
This article is part of the HT Friday Finance series published in association with Aditya Birla Sun Life Mutual Fund.