If you were one of those fortunate enough to learn at least a smattering of economics in high school, you might recall hearing about the disturbing things known as "asset bubbles."
First, we should define the word "asset, which isn't as easy as it seems. It would help if you understood that income is not the same as assets.
Typically, income is money flowing into individual or business accounts. Assets, on the other hand, are cash or property already owned by individuals, groups, or companies that have a chance to become more valuable.
As you probably know, accumulating assets is one of the proven, reliable methods of building wealth. Myriad things meet the broad definition of an asset, such as investments, collectibles, homes, cars and boats, and real estate. Your office building, inventory, accounts, and intellectual property are considered assets if you own a business.
What are asset "bubbles?"
It's perfectly normal for prices to rise and fall in a given market, but they typically tend to do so based on the fundamental value of those assets over time.
When the price of an asset spikes without any justification for the increase, you have a "bubble." Bubbles differ from ordinary price fluctuations because they exceed market equilibrium prices, remain high, and often continue climbing.
For example, many economists feel that the recent US housing market was overinflated due to speculative investing and changing demographics and thus was in a bubble. Also, bubbles may occur when there is an increase in the money supply (i.e., "stimulus" funds) and easy credit flowing into a market. When there is more money, buyers often bid prices higher and higher. In a bubble scenario, this flow of new funds keeps costs inflating beyond the value implied by supply and demand.
Bubbles are often deceptive and notoriously unpredictable. They generally fall into distinct categories: credit bubbles, commodity bubbles, stock market bubbles, and market bubbles. Even though they may be difficult to predict, bubbles have specific lifecycles. Knowing the stages of a bubble's lifecycle may help you better prepare for them.
Economist Hyman Minsky's theories about what creates financial instability and how such instability affects economies include what Minsky said are the five steps of a typical credit cycle.
The Displacement Phase: Displacement occurs when investors become attracted by shiny new things, such as technological breakthroughs or historically low interest rates. They flock to assets promising to deliver the hottest advancements or invest in real estate simply because rates are lower than anyone can remember.
Boom: Displacement leads to prices rising slowly at first, gaining steam as more people hop on the bandwagon. Boom is the stage where FOMO (Fear of Missing Out) kicks in as more people rush to get into an investment before the opportunity evaporates.
Euphoria: People begin spending money like drunken sailors on shore leave, throwing all caution to the wind. During this phase, asset valuations go to extremes, and increases are relentless.
Profit Taking: Sensing the shape of things to come, savvy investors begin selling out their positions and taking the profits. However, attempting to time a bubble's collapse is challenging, at the very least.
Panic: When the panic stage hits, asset prices reverse course and fall as quickly as they go up. Supply overtakes demand, and prices plunge. Now, faced with evaporating value and perhaps margin calls, investors want to offload their assets, even at a loss.
Now that you know some signs of bursting asset bubbles, you may think that this situation only affects very wealthy people. However, that is not the case. Bubbles can destroy individual and corporate wealth, especially for those who bought at the top of the market shortly before the bubble popped. Price bubbles are responsible for some of the worst recessions and depressions ever experienced in the United States. Besides the Great Depression, which resulted from a deflated stock market bubble, we've had the Dot.com and real estate bubbles of the 2000s, both of which led to economic crashes. Millions of dollars in net worth, including money in 401ks and IRAs, were wiped out in 2008, and businesses failed, resulting in debt deflation, unemployment, and widespread economic pain.
What can you do to protect your wealth when a bubble is bursting?
This article isn't intended to give you investment advice or to steer you in a particular direction. However, when you look at past recessions, you'll see that some investors managed to grow their wealth against all odds. There are actions that most of these people took.
They had written plans and followed them. If you don't have a comprehensive written financial and investment plan, you need to get with your advisory team and make one- STAT! Please do it now before you succumb to the irrationality and fear endemic to a fluctuating economy. Do it while you are relatively calm and level-headed. Anticipate various scenarios with details on how you will realistically position your assets to deal with each disaster.
Adhere to your plan religiously, regardless of what the pundits are saying, regardless of market gyrations and your emotions. You must hold yourself accountable any time you leave your path.
Yes, I know it's difficult, perhaps even impossible, to remove all emotion from financial decisions. But having your strategies written down will help blunt some of the emotional impacts and possibly keep you from making mistakes in the heat of the moment.
Pay off as much debt as you can. People who thrived in past recessions got out of debt. Rising interest rates that typically accompany popping bubbles are unkind to debtors. Don't be tempted to take on more so you can snap up all the inevitable "bargain" assets you'll see in the coming months. Don't gamble with money that isn't yours. If you do, you may be forced to sell assets for much less than they are worth to pay off your debts. Is that something you want to do?
Meltdown survivors do their research. Don't allow FOMO (The fear of missing out) to control your responses as assets go on the market. Do your due diligence before purchasing if you're on the sidelines and see something you think is a bargain.
They set absolute return thresholds for all their investments. Many convince themselves that they must take advantage of whatever is on the buffet table, even if they don't particularly like what's being served.
Instead of waiting for intermittent but excellent investments that come along once in a blue moon, some folks select the least unattractive item on the table just because it's there. It would be best if you never did this. Instead, give yourself an absolute return threshold. Become a long-term thinker, and don't put any money into an investment until and unless you are confident it will exceed your threshold.
Survivors are willing to do nothing and earn ZERO.
Doing nothing is often a wise course of action, especially when markets are free-falling and so-called experts are in full panic mode. If you pressure yourself to make decisions because you're afraid to earn nothing, you may lose tons of your capital. Unfortunately, if you lose money, especially within ten years of retirement age, you may not have enough time to recover from those losses. In times of high volatility, most of us can't afford to lose even a single penny of our cash.
Bubbles are part and parcel of the financial system. The bursting of asset bubbles may lead to stress and chaos in the marketplace and individual portfolios. A written action plan with protocols for dealing with various post-bubble scenarios can help you survive and perhaps even thrive amidst the panic. Meet with your financial advisory team regularly to ensure your written plan is up-to-date and in line with your current situ