With housing prices making a strong recovery since the financial crisis of the late 2000s, it’s worth taking a look at what causes investments or industries to zoom to the stars and then crash back to earth. Industry bubbles generally occur because the incentive for profit is so powerful that it blinds us to rational thinking. While academic research of bubbles has found there is no reliable way to predict when a bubble will burst, industry experts generally agree that when prices or valuations expand well beyond their historical ranges, it’s likely that a bubble is forming. One of the latest examples is the China’s Shanghai Composite Index, where stock prices ran up over 115% in eight months then crashed 30% in a month.[1]

When individuals or companies are making money so easily, it’s easy to fall into the trap of being focused on making even more rather than worrying about what could go wrong. As more investors experience success, buzz grows and the market players may downplay risks because “this time it’s different.” Bubbles burst when the argument for an asset to keep going up starts to show cracks and reality sets in. During the dot.com bubble, the tipping point was startup companies continuing to burn through millions of dollars every month with no signs of profitability. In the housing market crash that ushered in the global financial crisis, homeowners started defaulting on their mortgages when no-interest or teaser rates expired and monthly payments soared beyond their ability to pay.

The bursting of financial bubbles will always exact some collateral damage on investment portfolios, but you can limit that damage by following some common sense rules:

1. Don’t Follow the Herd

Industry bubbles are enabled by more individuals buying into a fad. And many market participants are highly motivated to keep the momentum going, whether it be stock brokers, investment product marketers, the media, or even governments.[2] You can avoid getting caught up in the hype by tuning out daily market movements. Many critics warned about the financial system becoming susceptible to collapse years before Lehman Brothers went bankrupt, but their admonitions were drowned out by the greedy herd of profit-seekers.

2. Stay Diversified

By spreading your capital across different asset classes and investment styles, you mitigate risk by lessening the impact of a selloff in a particular sector or industry. An investor 100% in equities would have lost 37% in 2008, but owning a 60/40 mix of stocks and bonds would have limited losses to 13%.[3] Diversification also means owning investments that react differently to the same event. In the tech crash of 2000, large cap growth stocks lost 22% but large cap value gained 7% and bonds added 11%. You should also diversify based on your total wealth, which includes your job as well as your investment portfolio. So if you work in the retail industry, for instance, you may want to minimize your exposure to consumer stocks impacted by the same forces that affect your job. Keep in mind that a portfolio composed of many ETFs and index funds may have significant overlap among the underlying holdings. To ensure that you’re sufficiently diversified, you’ll want to know the contents of your funds and ETFs.

3. Rebalance

Industry bubbles can cause your asset allocation to get out of whack as prices rise rapidly. Check the allocation of your portfolio at least once per quarter and   any weightings that have increased well beyond your targets. If you started investing in a 60/40 stock-bond mix at the end of the last bear market in 2009, your portfolio is likely overweight in stocks and could use an adjustment. Periodic rebalancing can improve returns and temper risk by forcing you to take profits in winning investments and reinvest the proceeds in undervalued ones.

 

[1] Bloomberg. “Charting the Rise and Fall of China’s Equity Market.” July 7, 2015

[2] Forbes. “Lest We Forget: Why We Had a Financial Crisis.” November 22, 2011

[3] American Association of Individual Investors “Diversification: A Failure of Fact or Expectation.” March 2010.