Who Says You Shouldn’t Buy Stocks In A Bubble?

Who Says You Shouldn’t Buy Stocks In A Bubble?
Stéphane Renevier, CFA

over 2 years ago4 mins

  • Buying stocks when they’re in a bubble is a risk, sure, but so is keeping your hard earned savings in cash.

  • You can’t time the market, but you can invest less when they’re expensive and more when they’re cheap via dollar-cost averaging.

  • You could also wait for the market to crash and use momentum to avoid at least some of the fall, or protect your portfolio by buying insurance.

Buying stocks when they’re in a bubble is a risk, sure, but so is keeping your hard earned savings in cash.

You can’t time the market, but you can invest less when they’re expensive and more when they’re cheap via dollar-cost averaging.

You could also wait for the market to crash and use momentum to avoid at least some of the fall, or protect your portfolio by buying insurance.

Mentioned in story

You’re constantly being told how dangerously high markets are right now, and it’s true: it is a risk to buy stocks when they’re in a bubble. But it’s also a risk to keep your hard-earned savings in inflation-eroded cash. So I want to make a different case: don’t let a bubble stop you from investing in stocks, as long as you’re smart about it. Here’s why.

Reason 1: There’s no timing when a bubble will burst

Even if stocks are in a bubble, it’s close to impossible to know when it’ll burst. Stocks could rise for a few more years before a correction ever happens.

Waiting on the sidelines for a crash, then, mightn’t be the best gameplan, as the cost of missing out on returns in the meantime could outweigh the benefits of getting in on the cheap. Worse, you might get too scared to pull the trigger when the crash finally does happen, ending up with all your savings in cash – which, as we’ve pointed out, would see you lose money to inflation.

One way to keep investing without taking on too much risk is a strategy known as dollar-cost averaging: buying a constant amount periodically, regardless of the current price. That means if you bought $100 worth of Apple shares every month, you’d buy twice as many when they’re worth half the amount. So while you do still buy when markets are bubbly, you’re buying less, which should reduce the average price you pay in the long term and improve your risk-adjusted returns.

But there are two drawbacks to this strategy. First, you might have enough capital to invest right now. Delaying your investment across multiple future instalments, then, means you could miss out on returns if markets continue to rise. Second, the strategy won’t protect you much against a crash, even if it will improve your long-term returns (assuming stocks rise). You might be less exposed, but you’ll still experience a loss.

Reason 2: You don’t have to ride the crash all the way down

It might be impossible to perfectly time when the bubble will burst, but it’s not impossible to avoid the worst effects of the crash by following a particular market signal – price momentum, say. For example, if you sold your stocks every time the S&P 500 went below its value from a year before – i.e. whenever its 12-month price momentum turned negative – you’d have cut your losses in the 2000 and 2008 crashes by more than half.

As ever, though, this strategy isn’t foolproof: the problem is that price momentum can give false exit signals. In other words, there are periods when momentum turns negative but prices subsequently rebound, leaving you uninvested during the rally. This strategy also doesn’t try to time the exact top of the market: it waits for price confirmation that the trend has changed, which means you’ll always exit stocks after they start to fall.

Using 12-month price momentum is also only one possible strategy: what’s important is not really which exact signal you’re using, but rather that you have an exit strategy in place today – i.e. before the crash happens. As long as you’re aware of the signal’s strengths and weaknesses, buying stocks in a bubble could still make sense.

Reason 3: You can protect yourself with insurance

You don’t need to be completely subject to the whims of the market. Just like with your home or car, buying insurance is a good strategy when navigating bubbly markets. And there are two ways you can “insure” your portfolio against a crash:

Buy puts options on stocks: Puts rise in value as stocks fall, which means they’re guaranteed to work when the correction happens. But there are a couple of disadvantages too: put options can be very expensive, and managing them does require technical knowledge and a more hands-on approach.

Buy diversifying assets: Bonds have traditionally performed well when the stock market crashes, and while gold and the US dollar’s performances are a little less clear-cut, they’re two other strong safe haven candidates. Unlike put options, you don’t need to pay a premium for this protection, and you’ll even earn a return on the bonds you hold. That’s why most institutional investors use bonds as a way of diversifying stock risk. Diversification isn’t infallible, mind you, and there’s always the risk that your diversifying asset doesn’t perform when you need it most.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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