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August 06 newsletter

Investment bubbles and crashes

Investment bubbles and the subsequent crashes go hand in hand. A bubble has been described as being "any deviation from fundamentals", or "an upward price movement over an extended range that then implodes" (Kindleberger).

Past experience

The most recent crash following an investment bubble was, of course, the aftermath of the internet dot com party. The Dow Jones Index (measuring the big US stocks) rose over 150% from June 1995 (4,556) to December 1999 (11,500). If the Spice Girls weren't bad enough, we also had to endure watching the value of those US stocks then fall by a third (to 7,591 in September 2002).

In the 80s, we experienced big hair and the crash of '87. The NZX50 doubled between November 1985 (850) and November 1986 (1,682), before losing it all to sit at 941 in November 1987.

In the 70s, we had hippies and Muldoon. Residential property prices (in real terms) increased by around 20% in both 1973 and 1974, before stumbling by around 11% in 1975.

Are we in a bubble?

Any discussion on investment bubbles begs two questions. Are we in the middle of a bubble? And if we are, how can we ensure that we are protected from the "implosion"?

Bubbles are a curious thing. They seem to be identified as a bubble only after they have burst. Take the internet craze, for example. In hindsight, it was obviously a bubble. But, at the time, the value of shares was justified in the terms of the "new economy". During the bubble, the old ways of valuing an asset did not apply in the "new economy".

In my opinion, residential property investment is one potential bubble out there now.

There are two classic symptoms of a residential property investment bubble:

  • An increase in property values. It's not on the scale of the internet craze, but values have increased by 25%, 12% and 15%, versus increases in inflation of 1.5%, 2.7% and 3.1%, over the three years ending 2005.
  • Many people have a property investment, or are considering one. This is what I call the "taxi driver syndrome". We're in a bubble if you're in a cab and the driver is discussing his or her property plans.

How to avoid the pain of a bursting bubble:

  • Have a long term view, so that short-term dips in value won't affect your overall investment plan.
  • Have access to cash. If rents and house prices fall at the same time that interest rates rise, you don't want to have to sell at the bottom of the market because of a liquidity squeeze.
  • Don't follow the crowd. Just because your neighbour and taxi driver are getting rich in property, doesn't mean that this investment option is right for you. To the contrary, I suspect that the easier it looks, the closer we are to the bubble bursting.
  • Just as in the internet era, if there's talk of "special" reasons to justify higher valuations, runů
  • Do the research and make sure the "fundamentals" stack up.
  • Of course, I'm a financial adviser, so I have to suggest that you diversify your investment portfolio. But, hey, why listen to me? Warren Buffet didn't get rich by diversifying.

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