Have you ever been to a party that was completely rocking but came to an abrupt end? It was frustrating, right? You can look at stock markets in the same way, as it is a party, booming with growth and boundless optimism but is at a risk of ending abruptly. Assets being priced at a greater value than their true value can result in market bubbles. You must be able to spot a market bubble early before it bursts to ensure that there are no negative impacts on your portfolio. Let’s understand market bubbles and how to identify them with this detailed blog.
What is a market bubble?
When there is a speculative demand for an asset in any market, its price rises above its intrinsic margins. This is the point when a market bubble occurs. If the prices are being pushed to unsustainable levels, a market bubble occurs, which generally follows a predictable cycle.
The first stage is displacement when a trader’s excitement is sparked by an innovation, trend, or event.
This is followed by the boom, when the prices rise rapidly, breaking the balance of demand and supply.
Euphoria is created when everyone wants to buy that stock without considering the risks.
Traders start taking their profits as they sense the peak. And in the final stage, there is panic everywhere, as the bubble bursts and the price crashes.
Spotting the signs of a bubble
Look out for the signs that warn you regarding a bubble burst. It is not possible to predict a bubble burst accurately.
Excessive valuations
If you see a stock, real estate, or other asset trading at a much higher price than its historical averages and intrinsic values, it is a warning sign. You must analyze whether any given asset is overpriced using the correct tools.
Herd mentality
You can easily identify FOMO through irrational behavior. When everyone else is doing it, I also need to do it! This is the exact feeling when a bubble is forming. Watch out for early trends of the overheating of markets.
Overleveraged buying
In the rising markets, traders want to participate and borrow large amounts. This increases the risk of the market as margin levels increase significantly. This can also result in a sharp fall in prices.
Priced and fundamentals are disconnected
If you see that the prices have detached from the underlying asset value, it is a warning sign for you. It is a noted fact that when the valuation of a company exceeds its earning growth, a bubble is often formed.
Speculations everywhere
When the market is being driven by speculative demand with no trace of long-term motives, there is a risk of bubble formation.
“This time it’s different” narratives
Claims that traditional rules of economics and stock markets are no longer applicable result in risks. If you are hearing such claims, it is probably indicating that there are a lot of speculations going on in the markets.
How to protect yourself?
The first step here is to create a diverse portfolio for yourself. By mixing stocks, bonds, real estate, and other alternatives in your portfolio, you can easily fight against a bubble. The bubble formed might result in a greater risk for one certain asset class, having all can be helpful.
Do not just follow the hype! When it comes to smart trading choices, the use of fundamental analysis is highly recommended. The bubble dynamics is a trap for you and companies who maintain a proper balance sheet are protected from such bubbles.
Turning points in the market are often driven by extreme optimism or pessimism. You can easily identify if the market is heating or not with the help of tools that are readily available. Paying attention to the sentiments of the market can be the right choice to avoid unwanted mistakes and problems.
You can also make use of halt-loss orders to automate the selling process before it is too late. This feature enables you to sell your stocks when it falls to a certain level to ensure that you do not face major losses, in case, there is a bubble burst.
Avoiding leverage is another precaution that you should take. Borrowing might increase your returns but it also can result in higher losses. You should not use margin or excessive debt in funding your trades.
What to do in a bubble?
The first thing to do if you spot a bubble is sell some or all your holdings in that stock. You can lock your gains by withdrawing the holdings at the right time. However, you might miss out on the final parts of the rally, but you are protected from unwanted dips in your profits.
Hedging your portfolio can be a beneficial step that can keep you protected in a bubble. Hedging options can include buying put options or shorting overvalued assets. These strategies can help in protecting your portfolio when the market is correcting itself.
You can face unwanted losses if you panic and sell your stocks unnecessarily when the bubble bursts. Do not sell in a rush if you are holding stocks that have a strong fundamental.
Patience and discipline are important
You need a mix of vigilance, skepticism, and discipline if you want to spot bubbles better. If you see the market defying logic it might be a warning sign for you. However, if you drag yourself into the mess, you should focus on your long-term goals and stick to the correct strategy you have prepared.
Market bubbles can result in major losses for you! Stay protected by using the principles of valuation, sentiment analysis, and risk management. Use all the knowledge you have to make the right decisions and avoid major losses that you might have to face due to a bubble. Use fundamental analysis and stick to your strategies at all times. These areas can be beneficial in minimizing the impacts of a bubble burst on your portfolio. You should always make sure that you withdraw your holdings as soon as you detect a bubble to avoid unnecessary losses!