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Bubble trouble: What, why and how?

January 05, 2010 17:47 IST
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Remember the dot-com bubble that formed in the 1990s when almost every man and his dog invested in dot-com companies blindly driven by the price rise and with little or no insight into what these companies were really worth!

And none can forget the dot-com bubble burst in the year 2000 that gobbled up nearly half the value of Nasdaq!

Today the situation is probably similarly scary! Following the introduction of the hefty global stimulus packages to fight the global recession there is an increasing capital inflow into the world markets particularly in India refueling the worst fears of the investors: the birth of another bubble!

However, the Reserve Bank of India, the country's central bank has stepped in to allay such fears saying that the increased capital inflows in the assets markets were in line with the account deficit and this is no sign of an asset bubble building up at present!

However, the central bank was quick to add that it would take appropriate measures when such a situation arises! Alarming! Does it mean that there is a bubble in the making? Unfortunately, investors know of bubbles only when it bursts! So how should you protect yourself from a bubble? Before that let us see what a bubble is and how it is formed?

What is a bubble?

For the uninitiated, a bubble could occur if there is an unmatched increase in the price level of an investment in respect to the fundamentals of that investment.

How is it formed?

Bubbles are born and continue to grow when too many investors for more than one reason see more demand on an investment and subsequently more profits and throng to invest on such investments.

Sometimes too many investors might buy an investment when they believe that it will become profitable in a shorter span of time. Bubbles can burst in any commodity including stocks, and real estate.

Why you should guard against it?

It is almost impossible to predict the bursting of a bubble and if it does you are at the risk of losing out on your hard earned money put on investments. That's one big reason why you should be guarding against a bubble! It's your money and you wouldn't want to lose it, would you?

What is the strategy to protect against it?

Frankly speaking, the primary protection strategy would be to be less greedy! Yes, you heard it right! Though investing and making money is important it is equally important to do it wisely! Learn not to put too much money into assets just because it has witnessed or continues to witness a sharp increase in the last few months! Beware as it could be an impending sign of a steep fall!

Another important point is to realize one's investment goals and adopt a strategy in choosing the right asset allocation that is kept diverse with active management when the markets are up and kept passive when it is down all the time ensuring that it protects your investments.

Take for instance the insured asset allocation strategy that gives the best of both the worlds of active portfolio management and at the same time protect your investments!

This is done by setting a mark or a base portfolio value below which your portfolio should not be allowed to decline! That is when the markets are upbeat and your portfolio is well above the base value mark you could be active in managing it and increasing its value.

However, when the markets are nose-diving and you see signs of your portfolio value hitting the minimum mark you have set you could reinvest in risk-free assets to protect your base portfolio value.

In simpler terms, the insured asset allocation strategy has in it the options of put/call and future contracts that would ensure that there are more risk-free assets bought when there is a threat to the base portfolio value thus saving the investor's money.

Factors to be taken into account while opting for the strategy

A lot of investor participation goes into opting for the strategy to protect from market bubbles! An investor is better positioned when he possesses a strong financial knowledge, has more time to watch market movements and above all a basic understanding of the assets markets.

The investors' ability to make use of the various financial tools, online and offline will also help while opting for the right strategy.

Timing the bubbles is very hard for the uninitiated and hard for even the experts! There most popular bubbles of the recent decade are the stock market bubble in the early 90s post-Harshad Mehta scam and the technology or internet bubble in 2001.

Remembering the lessons learnt from these two most important bubbles is that always invest your money at regular intervals.

Never put all your eggs in one basket; diversification of portfolio, asset allocation and rebalancing are the most important thing to minimize your risks and losses in case of a bubble burst.

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