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How are Bubbles Formed and How to Avoid One

Since the beginning of financial history, there have been records of the formation of bubbles and every one of them is followed by a tragic but inevitable burst. The most recent example is the burst of the penny stock bubble involving Blumont Group  (SGX: A33)Asiasons Capital  (SGX: 5ET), and LionGold Corp  (SGX: A78).

How exactly does a bubble form?  More importantly, how can we, as investors, identify the next one and avoid it?

One of the best illustrations of the whole process of a bubble is given by billionaire investor, George Soros. In his theory of reflexivity, he describes how a typical bubble is formed. In general, it will have 6 main points of reference. Of course, not all bubbles follow the same path, but it is worth noting the similarities with many of the past bubbles.

Rodrigue Bubble Graph

Source: Dr. Jean-Paul Rodrigue, Dept. of Global Studies & Geography Hofstra University

Take off / Fundamental growth

This occurs when there is a genuine reason for growth, such as the discovery of a new technology during the dot com bubble era, or a release of easy credit during the housing bubble when interest rates dropped to 1% in 2003. These events will start the snowball rolling.

First sell off / Testing stage

This is the point where people will start questioning the growth and express concerns. If the bubble is able to pass this phase, it should set the stage for the boom cycle.

The boom

This is where more and more people catch on to the idea and concept until it reaches a point where people are just pouring money into it because someone they know has made money.

The new paradigm

Greed has taken over and people are publicly declaring “This time is different!” We see this when people openly declared that “The internet is going to change the world” and “House prices will never fall.”

Denial

At this point, most of the “smart money” has left and there are signs of cracks showing within the concept but people who are invested try to convince themselves that it is all going to be alright. During the housing bubble, when some of the sub-prime mortgages had started to go bad, most people were still hoping that it’s just a short-term correction and that everything is going to be just fine.

House of cards collapsing

It is all over, panic has set in, and prices are falling fast. Investors and speculators are now liquidating at any price due to margin calls or out of fear. Below is the chart of the Dow Jones Industrial Average (an American stock market index)during the housing bubble period (2003 – 2009). It is interesting to note a resemblance between the thereotical graph shown above and the Dow Jones’s actual up and downs during the housing bubble.

Dow Jones bubble graph

Source: Yahoo Finance

Foolish Bottom Line

Looking at Soros’ theory and Rodrigue’s graph, it seems easy to come to an erroneous conclusion that investors can ride on bubbles and exit unscathed since they know it’s a bubble.  Unfortunately, reality isn’t so kind.

Recent Nobel Prize winner Robert Shiller, who’s an economist well known for his research on bubbles, thinks it’s highly possible for investors to spot them. To able to tell when they’ll collapse though, is an entirely different story altogether.

To paraphrase Warren Buffett, investors who think they’re a dancing Cinderella who’s able to leave the ball exactly at midnight will soon find out that no one has clocks or watches.

Accordingly, if you ever think you’re seeing a legitimate bubble forming, it’s perhaps best to stay away.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.