With the volatile markets we’ve been experiencing the last couple of years, it’s no
wonder some people are afraid to invest anything in the stock market. Yet, if they have
a long investment time horizon, they need to have a portion of their portfolio invested in
equities, in order to keep up with inflation.
Following all the “Y-2K” hype (concern about the year 2000 date impact on computer
programs), we had the “tech” stock bubble burst and more recently the real estate
bubble/credit bubble fiascos. We are now hearing talk about a possible commodities
bubble as prices for all types of commodities (especially oil) have risen dramatically.
There is considerable concern now that prices have risen far more than current supply
and demand would dictate. These types of bubbles can wreak havoc on your portfolio.
It is generally accepted that the first bubble occurred in the 17th century in Holland
when tulip bulb prices soared beyond anyone’s imagination. A number of books have
even been written about bubbles, with a recent publication worth reading. Titled Trend
Watching, it was written by CNBC anchor Ron Insana (2002 Harper Business).
With more bubbles occurring in recent times, it’s become popular for academia to study
them. The center of this current activity is Princeton University, where three scholars
hired by our current Federal Reserve Chairman, Ben Bernanke, are using mathematical
models to study these market corrections. One of the three recently noted two key
features of bubbles: “People pay a crazy price and people trade like crazy.”
They point out that prices continue to rise because it’s harder to bet on prices going
down. Skeptics therefore move to the sidelines. This results in more buyers than
sellers and fuels the price increases further. Bubbles often are accompanied by
significant borrowing by investors wanting to get in on the action. As a result, even when
smart investors suspect a bubble, the bubble persists for some time. At some point
(difficult to predict), something will trigger a significant downturn in price causing a panic
by leveraged investors who sell to cover their debts.
So how can you protect yourself from a future financial bubble? The best way we
believe is to have a disciplined investment strategy that is founded on broad portfolio
diversification. We recommend that you establish a broadly diversified portfolio of asset
classes that are uncorrelated with each other. Utilize broadly diversified mutual funds,
exchange-traded funds (ETFs) and index funds.
Based on your risk tolerance, you should have an established target percentage for
each asset class. When an asset class percentage varies significantly from your target
allocation, we recommend you buy or sell to bring your portfolio into balance. If you do
this periodically (annually at a minimum) in a disciplined manner, you will never get
caught up following the hot stock of the moment. Doing this forces you to buy low and
sell high, just the opposite of what those investors who get caught up in bubbles do.
And if you just can’t resist getting into the action on some new hot stock, limit the
purchase to no more than 5%. That way, if it suddenly drops by 50% in value, the
impact on your portfolio would be only 2.5% (assuming your holding was 5% of your
portfolio).
But what if the whole market tanks? When the tech bubble burst, those with broadly
diversified portfolios weathered the storm fairly well. This was due to the fact that
several asset classes did well during those difficult times (real estate, some small stock
funds and bond funds). It’s also important to keep in mind that history has shown that
the markets often recover from disasters and financial crises much quicker than you
might think.
In summary, to avoid the next market bubble, make sure your portfolio is broadly
diversified and rebalance it faithfully in a disciplined manner.
David C. Patterson, CFP® and Erin Preston, CFP® are the owners of Patterson
Advisors, LLC, a fee-for-service-only financial advisory firm. Patterson Advisors, LLC is
a Registered Investment Advisor, registered with the State of Michigan, helping clients in
Waterford, Clarkston and Royal Oak, Michigan as well as other Oakland County,
Michigan communities . Visit www.pattersonadvisorsllc.com for more information or call
248-674-2108.
Published in the Oakland Insider, September, 2008, retitled: "How to Protect Yourself
from Inevitable Next Financial Bubble"
How to Protect Yourself from the Next Financial Bubble
By David Patterson and Erin Preston (formerly Patterson)