Wealth Watch: Explaining asset bubbles

When a market for an asset gets over heated you may often hear that it’s being described as an “asset bubble”. The terminology is exactly as it sounds, the price of the asset has grown well beyond its capacity and like a bubble rising in the sky it continues to reach impressive heights until it eventually pops and comes back down. This term is often used to describe a fanatical rise in an asset price without much substance backing the change.

It’s important to first understand what classifies a bubble. Just because an asset or investment has been moving notably higher doesn’t necessarily means it’s in a bubble. The actual definition is when there is a rapid escalation in the price of the asset often without cause and then an eventual ‘pop’ which is a notable contraction. Beyond this basic definition, there also tends to be a sense of mania that goes along with this price appreciation often leading to investors ignoring the intrinsic value of an asset and thus are willing to push the price well beyond its true value.

One of the earliest known bubbles occurred in Holland in the early 1600s. During this time the price of tulips had inflated well-beyond what their actual value was. Some of the rarer bulbs were considered to be a luxury good and their prices climbed dramatically, along with the most basic bulbs fetching huge sums. A futures market was established where investors could speculate on the price which then drove the prices even higher. The bubble finally popped when a buyer of a big order of tulips failed to show, which created a panic, and ultimately declined the price of tulips to tiny fraction of what they were trading at before. Fortunes were made and lost overnight.

As peculiar as a tulip-bubble may seem, you can take a different asset and repeat the same storyline.

One of the more recent bubbles in memory was the dot-com bubble which occurred in the late 1990s. At this time, investors flocked to the reality that the internet had the potential for big profits and poured money into any new internet-based company, regardless of profitability. This frenzy drove many new companies to start trading on the exchanges often for dramatically higher than their initial public offering (IPO) price. Eventually, this market peaked too and popped where by the end of 2001 many of these dot-com companies were bankrupt and gone.

Potential bubbles can be easy to identify, but the timing of their demise (or whether they will pop at all) can be more challenging to predict. Some investors speculate that the crypto-currency market is a bubble and although virtual assets such as Bitcoin have seen a notable decline from their highs set in late 2017 there may be arguably far more decline ahead. It’s difficult to say what the real value of something like Bitcoin is and therefore challenging to determine the proper price. Time will tell whether it can survive or not.

Another consideration closer to home is where cannabis stocks in Canada have traded. There has been a significant rise in their share price leading up to legalization and then almost on cue the share prices of many companies have sold off notably since that date. It’s not to say that this decline will continue but it is reminiscent of other bubbles.

A cautious approach should be warranted when there is a lot of hype around an investment. Before investing it’s helpful to ask some questions. Are people who don’t normally invest suddenly talking about an investment idea? Is the particular investment making far more news than usual? Has the price of the asset skyrocketed recently? All of these are warning signs of a potential bubble.

In any case, long-term investors may be better off focusing on companies and investments with a long history of sustainable and predictable profits, rather than hoping to get rich-quick. A bubble bursting can lead to serious financial loss. As always be sure to speak with a qualified professional prior to investing.

This is for information purposes only. It is recommended that individuals consult with their financial advisor before acting on any information contained in this article. The opinions stated are those of the author and not necessarily those of Scotia Capital Inc. or The Bank of Nova Scotia. Scotia Wealth Management is a division of Scotia Capital Inc., Member Canadian Investor Protection Fund.

Happy investing!

Derek Fuchs is a Senior Wealth Advisor with Scotia Wealth Management in Red Deer and holds the designations of Chartered Investment Manager, Certified Financial Planner, Financial Management Advisor, and is a Fellow of the Canadian Securities Institute.

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