Stock Market Swell.....

What is a financial bubble?  My definition of a financial bubble goes something like this…“An event that occurs because of an over-allocation of assets pouring into any particular market.”

What is the event?  Well, to illustrate, let’s imagine a water balloon.  The factory design of that balloon allows for a certain amount of water.  When water is added to the balloon, it begins to grow and tighten.  We will be able to fill the balloon as per the balloon manufacturer’s specifications.  However, any additional water beyond that will create a risk of balloon explosion.

When overfilling, the balloon displays certain obvious signs that it is time to stop the inflow of water.  You can almost hear the balloon stretching as it takes on more and more water, and at some point, we can now safely say that there has been an over-allocation of water to this balloon.

And then……POP!  The balloon not only retracts back to its original, pre-inflated state, it shreds beyond that and into tiny pieces.

This is exactly what happened most recently to the tech bubble of the late nineties, the real estate bubble that began shortly after, and the crude oil bubble that deflated in 2008.

What is generally true of stock market bubbles of the past, and almost certainly with any other bubbles not yet seen, is that the “pop” is usually more extraordinary than the slow and steady fill.

If you take away just one thing from this article, remember that financial markets tend to revert to their mean.

Mean reversion is simply a fancy phrase meaning that if particular market prices inflate larger than historical norms would suggest being reasonable (think real estate, oil, gold, or tech stocks here) watch out.   A bursting is at hand.  

When the talking heads justify the run-up in prices of ANY asset, ignore it.  Whether it’s the stock market, gold market, real estate market or any other market, there will be “experts” explaining why this time it puffed up market prices are here to stay.  Do not be swayed.  Simply realize that the more prolonged the advance, the more violent the decline.  And, yes, there will be a decline.

Two things are needed to circumvent the pain of a violent “snap-back” of financial bubbles.

1. Asset allocation.  Don’t participate in a bubble to an extent that when it pops, a large portion of your account is exposed.
2. Re-balancing of accounts.  If a certain market piece of your portfolio has run up because of a bubble, re-balancing your account to your preferred level of risk may reduce the shock and awe of the financial “pop” that is on its way.