If I say the 2000 dot-com bubble or the 2007 housing bubble, you immediately have a pretty good idea what a bubble is. Basically it’s when the price of some asset strongly exceeds the asset’s intrinsic value. The first recorded asset bubble occurred in the 1600s when the price of Dutch tulip bulbs went through the roof. Experts have tried to predict bubbles, but have largely failed. Bubbles are only agreed on retrospectively – once a sudden drop in prices has occurred. Indeed, within mainstream economics, many believe that bubbles cannot be identified in advance; cannot be prevented from forming; that attempts to “prick” the bubble may cause financial crisis; and that instead authorities should wait for bubbles to burst of their own accord, dealing with the aftermath via monetary policy and fiscal policy.
Several causes have been identified for bubbles such as excessive monetary liquidity; extrapolating past extraordinary returns of certain assets into the future; herd behavior (investors tend to buy or sell in the direction of the market trend); and moral hazard issues (when the risk-reward relationship is interfered with, often via government policy).
Okay, this is interesting, but how can it help you protect your assets from future bubbles? Well, first of all you need to be aware that bubbles continue to exist and are impossible to accurately identify before the burst (or crash) begins. Secondly, remember the definition in the beginning of this article: watch for situations when some asset is strongly exceeding its intrinsic value.
There are a few things going on right now that deserve bubble scrutiny. This includes stock market prices overall; housing in California (which often sets national trends); hot individual stocks such as Facebook, Tesla and Google; and cryptocurrencies.
Let’s drill down just a bit on the last one. The most famous cryptocurrency is Bitcoin, but Ethereum and ripple are important players too. Bitcoin’s value increased 343% in the past year and Ethereum is up 3,600%. Ripple increased from 23 cents per coin to about $3.00 in about a month.
Now these kinds of increases are a bit thrilling and it’s tempting to want to join the party. But cryptocurrencies walk like a bubble and talk like a bubble, so they just might be a bubble. My belief is there are other investment alternatives where prices are more in line with asset values. So, for my money, it just might be better to avoid the temporary thrill as well as the likely long-term pain of cryptocurrencies.
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