Crackle and pop! Why investment markets have bubbles

If you’ve ever seen a graph of a share market, you will know that while over the long term it tends to go up, the graph isn’t a straight line. Markets will go up, up, up over several years, only to fall back for a year or two, before re-starting their upward climb.

Research on US investors found that in the 20-year period ending in 2017, the S&P500 index returned 7.2% and the average share market investor experienced a return of 5.29% per year.

In the 10-year period ending in 2017, however, the numbers are worse: there was a market return of 8.5% compared to an average investor return of 4.88%.

And I don’t imagine Australian investor figures would differ too much.

The under-performance of investors has been observed for many years, so what’s going on? And how does it relate to market bubbles?

Market bubbles, and their subsequent busts, reflect over-reaction. We bid up prices beyond that which makes sense, and then on the downward slope, we sell when we don’t need to, and prices go below what logic would dictate they should be.

These extremes have nothing to do with balance sheets and profit and loss statements, and everything to do with human behaviour.

Market bubbles don’t occur because investors are stupid. They happen because we’re human. We’ve learned through thousands of years of evolution that if a lot of people are running in one direction, it’s probably wise to do the same.

So when markets keep rising, as we’ve seen in Australia over the past decade with residential property for instance, or when they fall, like we experienced with global share markets through 2008, our inbuilt, human reflex, is to jump on the bandwagon.

Another force at play is a concept known as Recency Bias, or in other words, the act of disproportionally considering things that have happened recently, and dismissing older information.

So why should you care about investment market bubbles?

The answer ties in with the statistics I mentioned in the introduction. Investors could have earned almost 2% more each year had they not followed the madness of the crowd. They bought and sold when they should have just left things alone.

Selling is what does the real damage. There is no perfect time to buy, it’s only known with the benefit of hindsight, and the cost of waiting on the sidelines can be significant. But selling is something we can be smart about.

To start with, don’t sell when markets are in a panic. Recognise the herd mentality and step back to consider what’s right for you. If you’re still building wealth, a market fall is actually an opportunity for you to buy investments at lower prices.

Next, be aware of your own recency bias. In 2008, I had clients say: ‘My balance has fallen x% this past year. If it keeps going like this for another 5 years, I won’t have enough to retire on.’ But hang on, we know that the long-term average return for growth type portfolio’s is about 8%. So why would you extrapolate last year’s down year and assume that’s what the future holds? Recency bias: applying disproportionate weight to recent returns.

Re-balancing portfolios can be a useful tool. That’s the process of periodically selling down investments in particular asset classes that have done well, and re-allocating the proceeds to the under-performing sectors. So for instance, if the Global Share portion of your portfolio had a very good year, you would sell down some of this holding, and reallocate it to the weaker sector, perhaps Australian Bonds. Considerable research has shown that this re-balancing process can add significant value, but it goes against the grain. It’s the opposite of what we naturally want to do, so it requires discipline.

To wrap up then, investment markets experience bubbles because humans make it so. And despite all the advancements in technology that we’ve seen in recent years, human behaviour hasn’t changed, so bubbles will continue to occur.

So what should you do? Be a long-term investor. Ensure your wealth strategy won’t force you to sell when markets drop. And if your strategy doesn’t already have a re-balancing process, explore how you might be able to change things to gain this valuable feature.

Important Information: This information is of a general nature only and has been prepared without taking into account your particular financial needs, circumstances and objectives. While every effort has been made to ensure the accuracy of the information, it is not guaranteed. You should obtain professional advice before acting on the information contained in this publication.

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