bubble-burst

Bubble markets occur when stocks trade at inflated prices.

As bubbles are forming, people deny there will ever be a crash and instead make up stories to justify why prices are inflated.

Just before the housing bubble burst in the U.S., real estate agents in Florida cited baby boomers’ desire to own beach property as the driver of high prices.

Also, in the late 1990s, lots of money managers knew tech stocks were overvalued based on price-to-earnings ratios, but continued to buy and sell, believing people would buy stocks at high prices indefinitely.

Bubbles are like musical chairs. People trade stocks at prices much higher than their intrinsic values, and when the music stops everyone rushes to the exits. Everyone thinks they can seize a chair before the other guy.

What intensifies a bubble?

Certain conditions make bubble scenarios more likely. In the early 2000s, my colleagues and I conducted a study to learn about these conditions. Over a set period, participants pretended to trade stocks, earning dividends according to a random draw at the end of each period.

In one scenario, there was a small chance of receiving a large payoff at the end of the dividend distribution period (similar to a lottery).

Even though people knew the large payoff was unlikely, stock prices kept rising—a classic bubble scenario.

The investors viewed the probability of a big win as higher than it actually was; and some thought they could take advantage of perceived arbitrage opportunities.

Also, when we provided traders with easy access to borrowed funds to finance their purchases, bubbles formed more rapidly. When less cash was available, price increases weren’t as severe.

Another way to diminish bubbles is by allowing short-selling—which allows traders to profit on a falling stock price.

While short-selling can trigger volatility in markets, and in worst cases lead to market manipulation, it also pushes down inflated prices.

How to help clients

Everyone has the potential to get caught up in a bubble. If I’m a DIY investor who sees rising prices in a particular market, I may start to trade more frequently.

Advisors must talk clients down when they get excited. Help them understand they cannot control what others are doing, or what’s happening in markets—make them understand they can only control their own behaviours.

To illustrate this, show clients market trends over the last 100 years. While there have been bull markets, these have generally been followed by long stretches of bear markets. Providing solid evidence of market trends will help keep clients’ emotions in check.

And while your clients should periodically check their portfolios, excessive attention to market movements is not helpful and will create added stress. Instead, tell people to file their statements, unopened if necessary.

This decreases the chances of clients becoming overly optimistic when they see the value of assets going up (or overly depressed when they see them going down).

Richard Deaves, professor of finance and economics at McMaster University

Originally published in Advisor's Edge

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