Bubble, Bubble?

17.05.11

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The recent sudden fall in commodity prices led to headlines asking if the commodity boom was over; if commodities were the next tech; if the bubble was bursting etc. A sustained fall may be welc

The recent sudden fall in commodity prices led to headlines asking if the commodity boom was over; if commodities were the next tech; if the bubble was bursting etc. A sustained fall may be welcomed by consumers but would be worrying for investors. However when asset prices fall like this it does not usually signal the start of a bear market; more often than not it?s a short-term correction, perhaps a necessary one if prices have got ahead of themselves.

Hindsight is a wonderful thing. Looking back, we can see which investment bubbles were formed, when they started and when they burst. If we could go back in time we?d buy and sell assets at the right time and make a fortune. But of course life doesn?t work that way. It?s impossible to say definitely now whether or not commodities will be the next bubble, and, if so, when it may burst.

So what we need to do is set up our portfolio to reduce exposure to potential bubbles. The recent commodity headlines are a good example of the importance of adequate diversification and a reminder that your choice of assets should be based on an overall strategy designed specifically around your circumstances, and not on what the latest trends are.

A bubble is a self-perpetuating rise in price of an investment asset. As its price increases, investors and speculators, attracted by what they?ve seen so far, buy more of this asset in anticipation of healthy profits. They often don?t stop to consider if an asset price is overvalued. As the price keeps rising they remain invested, lured by the prospect of further, bigger gains ? but then the bubble bursts.

And yet many people don?t learn their lesson. Many investors were stung by the technology ?dot.com? bubble of the late 1990s, and yet many simply moved into another bubble ? property. They saw property as a safe alternative to equities. They got as excited about property prices as they had about tech shares a couple of years earlier. But the property bubble eventually burst too.

Another lesson many investors don?t learn is that the ?buy and hold? strategy is a more reliable strategy than trying to time the market.

Dalbar, a US financial services research firm, has been publishing an annual Quantitative Analysis of Investor Behaviour report since 1994. Its latest report looks at the 20-year period up to 31st December 2010 and found that the annualised returns for equity investors was 3.83% – compared to the S&P 500 return of 9.14%. Likewise fixed income investors earned 1.01% versus the Barclays Aggregate Bond Index annualised return of 6.89%.

Dalbar explains that one of the reasons investors fall short is because they react to market movement and news. While chasing performance, investors shift money out of lagging funds and into ?hot? ones at the wrong times. They buy high and sell low repeatedly.

The results were consistent with previous years. Dalbar concludes:

?No matter the state of the mutual fund industry, boom or bust, the key findings remain consistent: Investment results are more dependent on investor behavior than on fund performance. Mutual fund investors who hold on to their investments are more successful than those who time the market.?

Looking at the dot.com bubble as an example, according to Morningstar, in the first quarter of 2000 investors poured $97 billion into equity funds – nearly double the total of the previous two quarters – right before the S&P 500 peaked on 24th March 2000. And in the third quarter of 2002, they withdrew $41 billion from equity funds just before the market bottom on 9th October, therefore locking in their losses.

So, what lessons should we learn? The first is to remain focused on what makes sound investing sense ? diversification. Your portfolio should be based on your personal objectives, risk profile and circumstances. It should be diversified first across assets (equities, bonds, property, commodities, cash etc) and then across countries, sectors, capitalisations and perhaps currencies.

You should then usually stick to your portfolio plan in both good and bad conditions. So if other investors start piling their money into ?the next best thing?, whether it be tech stocks, oil, property, mining stocks, gold or whatever, you resist the urge to overexpose yourself to these assets, especially by moving capital out of other ones. The higher an asset rises in value, the more risky it becomes so your risk levels increase as well. You may want to increase your allocation slightly, but without going overboard and without drastically changing the risk profile of your portfolio.

The same usually goes in bad times ? this is harder to stomach but you should not sell out of fear because asset prices have taken a tumble. Usually it?s just a temporary correction and chances are that you will be too fearful to buy back in until it is too late and you?ve missed the recovery.

Another lesson is to occasionally stop and review your portfolio to ensure it remains in line with your risk profile and objectives. If one of your assets has been overperforming, the temptation is to leave it to make more profit ? but in so doing you could be overexposing yourself to a potential bubble. If you took your profits and invested them in different assets you?d be giving yourself a better spread.

For confidence that your portfolio is based on a sound investing strategy discuss your objectives and situation with an experienced and regulated wealth manager like Blevins Franks Financial Management Limited.

By Bill Blevins, Managing Director, Blevins Franks

11th May 2011

Tax rates, scope and reliefs may change. Any statements concerning taxation are based upon our understanding of current taxation laws and practices which are subject to change. Tax information has been summarised; individuals should seek personalised advice.

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