It is not an easy decision to abandon an investment when it skyrockets and generates much more profit than expected. However, the option not to proceed is prudent when the investor suspects that they have entered a financial bubble.
In other words, you realize that your investment, after delivering an extraordinary return, which is very good, is worth much more than the better prospects for the company in which you became a partner justify. The profits come simply from the force of a great wave of purchases, made up of people who, many of them, hardly know the business.
Exiting investing in this situation comes at a price: giving up on making even more profit while the market party keeps rolling, and no one knows for sure when the party will end. The price of continuing, however, may be much higher because, of course, the fate of each bubble is a day to burst.
My point of view is that if the investor anticipates a speculative move too much, selling an asset too early, it can leave returns on the table that could greatly increase their capital. If, on the other hand, you let it go when prices start to adjust, it may be too late and you will suffer significant losses. You will be forced to hear from your friends and family that only the naive were caught up in investments that were "obviously" speculative.
The worst thing for an investor is being in a bubble when it bursts and the second worst is not being in a bubble when it is forming. Many people do not want to get out of the bubble, although they suspect it is a bubble. For an asset manager, for example, leaving means losing performance. It is very difficult to stay out of a bubble.
How bubbles form
Unfortunately, the existence of financial bubbles is only discovered when they burst. The formation of bubbles, however, has some common characteristics, which serve as clues for the investor to adopt a more cautious stance or even, according to their conviction and knowledge of the market, to bet on short positions that will bring benefits if, in fact, Asset prices plummet.
Price above value
There is the price at which a share is traded on the stock market, and there is the value that each investor sees in the share, considering the growth potential of the company based on fundamentals such as economic scenario, business plan and activity sector . If the price quickly reaches prices much higher than the value calculated by the investor, it may be a sign that the stock has broken away from the fundamentals, constituting a bubble.
Herd
An unfounded investment can be made simply by following the buyer's flow. If a lot of people are buying and the stock just goes up, the investor understands that the asset is promising and doesn't want to be left out of the party.
It is the so-called herd movement, which generates demand that forms bubbles and becomes more evident when investing becomes very popular, to the point of attracting lay people who heard stories of people who made a lot of money.
Example: the bitcoin bubble. Even without endorsement, supervision, and regulation, virtual currencies rallied more investors than the stock market, topping $ 19,000 at the end of 2017. A year later, with the bursting of the bubble, bitcoin was already worth less than $ 4,000.
Ease of access
Bubbles can be fed with the ease with which assets are acquired. The low-cost credit supply generates, for example, a demand that may not be sustained if the outlook is reversed.
It happened in the North American real estate bubble, generated by a financing structure that allowed the purchase of real estate even to those who could not prove income, employment or guarantees. When interest rates rose, defaults appeared and the bubble burst in 2008, taking the banks with their portfolios loaded with mortgage bonds.
One of the signs is when a large number of unknown people with the asset, who until then did not know it, begin to migrate towards it. In 2017, I was in the US and on every Uber ride I took the driver told me about virtual currencies, which I was making a lot of money with. When such a specific investment reaches this level of popularity, it is the first sign of a bubble.
Incorrect indication also helps to generate bubbles
One way to find out if a stock is overvalued is to monitor how financial analysts value it. To define what would be the "fair price" of an asset, they project the future results of the company, which involves variables related not only to the company, such as business management, but also to the direction of the economy.
When the stock is trading above the "fair price", it means that it is expensive and, therefore, it is advisable to sell or not to enter the paper.
However, there would be no bubbles if these recommendations were perfect, as there would always be a warning to investors before they were formed.
In the real world, however, wrong investment recommendations end up being one more factor in asset overvaluation, using wrong assumptions to justify indications to buy papers that are, in fact, already expensive.
Bubble thermometers
A good starting point for identifying bubble risk is to investigate whether the multiples of a stock are out of the curve.
For example, if the P / L, which compares the price of the share (P) with the profit generated by the company (L), is above the historical maximum of the paper, the investor must evaluate if any fundamental change justifies the behavior of the price. .
Does the company have technology that will revolutionize the market? Has your sector of activity had regulatory changes that increase the interest of international capital?
In other words, paradigm shifts may explain why investors are agreeing to pay more for stocks. However, if there is no plausible justification, the stock price may have broken off fundamentals, triggering the bubble warning signal.
The exponential increase in the price of the asset without any change in its fundamentals would be an indication of the beginning of the bubble, especially if the increase occurs frequently. An increase in P / E can be considered an indicator, but the best way is always to study the fundamentals of the company and invest without speculation.
The P / L is an excellent fundamentalist multiple to check for detachment from reality. Rather than looking at the historical average of the P / E, we have to take the historical average of the maximum of the multiple for at least ten years. It is generally at this level that assets are considered expensive.
Tempting, the bubbles invite investors to postpone the sale
The perception that a bubble has formed in the market indicates that the time has come to realize the return on investment. After all, the investor has already earned more than he bargained for and understands that the asset is costing more than it should.
Loading the investment for a longer time means running the risk of losing a good part of the profit obtained at any time, since, one day, other investors will realize that the paper became too expensive, triggering a herd movement in the opposite direction, in which the market begins to sell the asset en masse, causing a brutal drop in prices.
However, staying in a bubble is tempting. The desire to make the most of the financial market party invites the investor to postpone the exit as long as possible.
Also, it is difficult to make a correct diagnosis of the blister. Evaluation errors can lead to an investment landing long before it reaches its full potential. Stories of stocks that seemed overvalued to some and continued on an upward trajectory for years are not uncommon.
The vast majority of bubbles, if not all, burst due to human greed, a lack of common sense in the pursuit of money. This has happened since the first bubble, in 1637, with Tulipamania, as well as with the bitcoin bubble in 2017.
Bubbles are created by the behavior of investors who, driven by speculation, mania or market inefficiencies, are exposed to excessive risks, generating a spiral of high prices.
For those who want to pay to watch, the offers offer protection.
Buying put options, called put options, works as insurance for investors worried about the imminence of a bubble burst, but who do not want to ditch the investment.
Puts ensure a minimum selling price for the shares. If the market crashes, the investor knows that he will have the right to sell his shares at the price specified in the put options. If you don't need to exercise that right, great, it means the investment continued to make a profit.
For those who do not have shares, but are interested in speculating on the bursting of the bubble, the purchase of put, as well as short sale operations, in which the investor benefits from the devaluation of assets, brings profits extraordinary if, in fact, burst of bubbles. However, the risk here is high and it is not recommended for conservative investors or those with little experience and knowledge of the market.
The best way to avoid bubbles is to always highly diversify your portfolio across various asset classes and markets, as well as avoid investing in periods of euphoria.