If it sounds too good to be true, then it probably is.
Every single year, investors face stock markets with drastic ups and downs, making investors nervous about their volatility. That’s because markets have always faced extreme changes throughout the centuries. During difficult times, how can investors avoid asset euphoria? Additionally, how can you prepare for these wild fluctuations in the market?
Market Booms and Busts
We have all heard or read about major occasions where the market fell or rose dramatically. Markets can and do rise, of course, due to strong economies. Certainly, these are good market booms. However, sometimes there are market bubbles that lead to unreasonable market booms. Bubbles occur when investors pour money into a specific stock or market segment. Consequently, these bubbles inflate the actual value of the businesses and products.“Asset euphoria” describes investor interest in a bubble stock or sector. Like soap bubbles, they keep growing but eventually pop because there is nothing substantial holding them up. Here are some examples:
Tulip bulb mania (Holland, the 1630s)
Holland’s upper classes competed for the rarest Tulip bulbs after tulips became a status symbol. Tulip bulbs were then traded on Dutch stock exchanges, so all members of society were encouraged to speculate on them. During the height of the market, tulip bulbs traded for several times the average Dutch annual salary. However, tulip bulb prices eventually dropped. Eventually, panic selling set in, which left many investors in financial ruin.
Mississippi Company (France, 1719-1720)
The French economy was in dire straits, and the national debt was restructured under the auspices of the Mississippi Company, which was given exclusive trading rights for the various French colonies. Numerous continental traders rushed to buy shares in the Mississippi Company and soon the stock was worth 80 times as much as all the gold and silver in France, so the French government could not cover its debt (the shares in the company). The value of the shares plummeted, and investors took substantial losses.
Dot.com Bubble (2000-2002)
The excitement of the Internet, with its promise of an international market for goods and fascinating new ways of communication, overwhelmed many investors. Since investors blindly bought newly issued stock from the IPOs of Internet companies, markets zoomed upward. Surprisingly, these investors never bothered to look over the companies’ business plans. Unable to make money, many of these Internet companies reported huge losses and began to fold.
Housing and Mortgage Crisis (2007-2009)
Rising home prices led to rampant real estate speculation and a housing boom. This housing boom combined with low-interest rates led many lenders to offer home loans to people with poor credit. Investor firms bought these loans, then sold them as mortgage-backed securities to large investors. When payments began to catch up with home buyers who could not afford them, foreclosures jumped dramatically. This led to enormous losses for banks and investment firms that traded in these mortgage-backed securities. Many people lost their homes, and many banks lost lots of money. This led to a global credit crisis.
Preparing for the Booms and the Busts
How could investors NOT see these things happening? How could this “asset euphoria” have continued? It is obvious to us now why the busts happened and what we would have done differently, had we been there. However, even the wisest investors found it difficult to imagine the massive problems that would develop. We can quantify, analyze, and monitor market trends, but we cannot predict the future. All that investors can do is be ready for changes in the market, whether mild or massive.
How does a wise investor prepare to enjoy any booms and protect against any busts? To avoid falling prey to the lure of “asset euphoria,” as seen with the bubbles described above, remember the adage: “If It sounds too good to be true, then it probably is.” Discuss this with your financial advisor.
Diversification Matters
To avoid losing large amounts of money due to market changes, the best move is to diversify your holdings. You spread the risks around. Over the long term, you will reap the benefits of many investment sectors, rather than suffer massive losses when a bubble bursts in one of them. Your financial advisor is an expert on diversifying your investments by investing wisely in various sectors.
Just imagine how much better off the tulip bulb, Mississippi Company, Dot.com, and mortgage-backed security investors would have been if they had pondered how something can sound “too good to be true”. And even if they ignored that warning and jumped for the new asset, just imagine how much better off they would have been with a diversified set of investments. They would face crushing financial losses, but only in one part of their financial portfolios.
To balance your investment impulses and diversify your holdings properly, the best move is to see your financial advisor.
