Bubble Checklist: 3 Questions You Should Ask Yourself Before Investing in Anything

Whether you're a first-time investor or have been investing for many years, there are questions you should always ask before you commit your hard-earned money to any investment? In this article, you’ll find 3 important questions you should ask yourselves before you invest.

13 January, 2020 – HYCM - Assets don’t make bubbles, people make bubbles. The fact that at different points in history these bubbles have involved everything from tulips, to houses, to bitcoins says a lot more about us as human beings than it does about those specific assets. That’s the fascinating thing about the markets; they represent the aggregated hopes, fears and delusions of their individual participants.

Nevertheless, it is shocking how oblivious most people are to the markets even when they’re participating in them. Anyone who has ever borrowed money, bought a vehicle, a property or exchanged one currency for another has taken part in a market. Because nobody goes out of their way to teach us about how they work, we tend to view those transactions simply as services that we go to different businesses for. This is also why ordinary people get hurt the most when a speculative bubble takes hold.

3 Investment questions you should ask yourself

Since there’s typically a bubble at some stage of inflation or deflation, we thought it would be helpful to provide you with a quick checklist for how to avoid them. Below you’ll find 3 questions about investing you should ask yourselves before letting your primal instincts take over and betting the farm.

1. Is everyone talking about it?

Perhaps one of the strangest bubbles in history took place in Holland in the early 1600s. What makes this bubble so odd, is that the object at its centre was the humble tulip bulb. Today you can buy tulip bulbs for pennies on the pound at your local garden centre, but at the peak of the madness the bulbs of certain rare varieties sold for more than ten times the yearly salary of a skilled craftsman.

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In his book Extraordinary Popular Delusions and the Madness of Crowds, Charles Mackay presents an extensive list of items from a real tulip trade made at the height of tulip mania. Investors were really exchanging the items below for a single tulip bulb of the Viceroy species:

“Four lasts of rye, four fat oxen, eight fat swine, twelve fat sheep, two hogsheads of wine, four turns of beer, two runs of butter, one thousand lbs of cheese, a complete bed, a suit of clothes, a silver drinking cup.”

According to Mackay, when the madness for this recently-introduced species of flower took hold, it caused people at all rungs of Dutch society to suddenly pivot into becoming tulip cultivators, brokers and speculators.

“A golden bait hung temptingly out before the people, and one after the other, they rushed to the tulip marts, like flies around a honeypot. Every one imagined that the passion for tulips would last forever and that the wealthy from every part of the world would send to Holland, and pay whatever prices were asked for them… Nobles, citizens, farmers, mechanics, seamen, footmen, maid-servants, even chimney-sweeps, and old clothes-women, dabbled in tulips. People of all grades converted their property into cash and invested it in flowers. Houses and land were offered for sale at ruinously low prices...”

People who were around in the US before the 2008 financial crisis will tell you that at the height of that particular bubble, everyone suddenly had become some kind of property agent, investor or developer. Similarly, at the height of the cryptocurrency bubble in 2017, many of us remember even elderly family members asking us about this bitcoin thing over Christmas dinner. These scenarios tend to repeat themselves because they’re so ingrained in our nature. So next time your friends, family, doctor, dentist, and postman start frantically trying to pitch you on the next amazing investment opportunity, you’ll at least recognise it as a sign.

2. Does both good and bad news make prices go up?

If the first item on our checklist had to do with sentiment, this second one is about fundamentals. When a price rally becomes euphoric, fundamentals cease to exert an influence on the price until long after the bubble pops. This is a classic sign that the asset in question is in a bubble. Once they get going there’s no rhyme or reason to bubbles. Even people holding assets that are benefiting can’t believe what’s going on as they watch their net worth skyrocketing. First, the market will start to discount any information that contradicts the bull case, then in the later stages, it will find a way to interpret any negative news as a good thing.

We saw this with bitcoin on its last push to $20k. Whether China was banning crypto or lifting the ban it went up. Whether hackers comprised exchanges or record sign-ups went up. When it became a victim of its own success and the network couldn’t handle the numbers of incoming transactions, it went up. Then, when community in-fighting about how to remedy the congestion led to development grinding to a halt, it went up. Even after several contentious bitcoin hard forks that spawned rival cryptocurrencies, it still went up.

Taking an informed position in such an environment is almost impossible. Those on the side-lines, or in uncorrelated assets, simply lose out. Those shorting lose their shirts - even if there was a terrifically good reason to short - and the only option left is to be long and thus provide further fuel to the fire.

3. Does its chart look a bit like this?

The third item on our checklist is all about the technicals. You don’t have to be a professional analyst to be able to spot patterns like the one above. Known and revered by traders across the globe, the image above describes what your typical market cycle looks like on the chart. It also labels the various peaks and troughs with the types of psychological sentiment that prevail at the time. It’s uncanny how closely real-world cycles - individual stocks or entire sectors - can resemble the above image.

We’ve circled the bubble phase of the cycle. In order to draw your attention to the fact that there’s very little consolidation that takes place once a bubble gets started. In other words, it more or less goes straight up without coming back down to re-test former highs. Another thing to look out for is that most of the buying takes place at the top. You can see this from the size of the green bars that go from optimism to euphoria. It may seem counterintuitive for most of the money to be coming in at the top but it is classic bubble behaviour, everyone piling in right before the party is about to end.

This ties into our first point, that people buying at these inflated levels are naturally the ones furthest from the action. These are the ones who find out about it last, usually after the media starts its heavy coverage. A good way to ask yourself whether you’re about to become one of these people is to slow down. Stop worrying that the opportunity of a lifetime is about to slip away and check what the price action looks like when plotted on a chart. Does it go straight up without any corrections? How far and for how long? Never forget that when you counterintuitively buy at the top of a bubble. You’re the dumb money that’s buying from the smart money that bought way back in the disbelief and hope stages.

One more thing

People make and lose fortunes in bubbles all the time. Some of those bubbles, like tulips, pop and never reflate again. Others trade at lows for extended periods before the market starts seeing the underlying assets as oversold. Whilst traders start piling back in again. Then the next cycle usually dwarfs the last one.

Housing works exactly like this, so even ask these 3 questions questions about investing before you invest in real estate. Also, the tech bubble of the late 1990s is another example. Whereas, the cryptocurrencies are arguably looking like they may be in the early stages of yet another cycle. The point is if what you’re investing in is worthwhile and here to stay, there’s no rush. Take some time to research where the price currently is in this cycle and plan from there. Remember, if you don’t know who the dumb money is, then it’s probably you.

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