Tips from Vanguard on Bubbles (NOT the fun kind!)

Vanguard published a great article on investment bubbles. As a provider of financial education, I constantly hear from women that they have fear around losing their money. Research shows that financial security is a top priority when it comes to women and investing; not that we need the research to know that, right, girlfriends?  Understanding bubbles helps you to avoid them, and thus, lower your investment risk.

Remember, knowledge is what makes you feel more financially secure. When you know about something, it just feels safer, and you make better choices. This is true for investment products as well as financial advisors.

Here are the 4 main points from the article by Stephen P. Utkus, director of Vanguard’s Center for Retirement Research:

1. Investment bubbles start inflating when investors become convinced that a hot investment, like mortgage-backed securities, will post unrealistically large returns in the future. This idea is fed from a human tendency to trust short-term data, which seems to show a discernable pattern, over long-term data that seems random.

Utkus goes on to explain that investors should have known that real estate has cycles, just like other assets. You may recall previous real estate bubbles; I sure do.

2. Most people think they are better-than-average drivers. This is obviously impossible. There have to be as many below-average drivers as above-average drivers. Investors and market analysts are no different in overestimating their abilities.

I love this analogy, but I am not completely sold on this one. I think it’s just hard to feel like you are missing the opportunity, for most investors. Besides, some individual investors do have above average returns; they are strategic and disciplined.

3. Imagine you’re at a concert. The person in front of you starts clapping their hands above their head in time to the music. You think they look silly and don’t join in.

But then the clapper’s neighbors start clapping. And their neighbors. Before long,  else in the audience is clapping. Now you look silly if you’re the only person who isn’t clapping.

This one is my favorite…been there, done that…both at the concert and the financial markets. What a painful lesson…with the markets, that is!

4. In the final stage of a bubble, the expectations for the hot investment finally come back in line with reality, resulting in a huge drop in the price of the now unpopular investment.

The fall starts as a trickle and turns into a mad rush for the exits.

 

Utkus makes three recommendations to avoid investing in bubbles.

• Become more Knowledgeable – Need I say more?
• Manage emotions– Love this one!
• Focus on the long term– I agree, but also regularly keep an eye on your near term investment performance.

The complete article is available here:

https://retirementplans.vanguard.com/VGApp/pe/pubnews/HowtoAvoidBubbles.jsf?z_rl=T61546605

There are few individual investors who have not fallen prey to financial bubbles at some point. If you are working your way out of a bubble investment right now, keep looking forward. Those difficult money lessons are often the best, even though they are painful! Been there, done that. A simple Financial Woman safety tip is to always compare the value of any asset to it’s average historical value before investing in it.