Investing in a Bubble: The Real Risk Is Sitting Out
By James Parkyn - PWL Capital - Montreal
Investors are both giddy and nervous as stocks keep skyrocketing upward to new all-time highs.
Are we in a bubble? Is a crash coming? If so, what should we do to be ready?
Investors spend an inordinate amount of time worrying about catastrophic market collapses—and never more so than during a booming market.
Who can blame them? Imagine the shock of waking up to discover you’ve lost 10 or 20% of a lifetime’s savings overnight.
But fascinating research shows that true market crashes are exceedingly rare, much more so than commonly imagined.
Only four crashes since 1887
In fact, the fear of losing money in a major correction is a bigger risk than a crash itself. That fear keeps many investors on the sidelines during the good days, which make up the vast majority of the life of markets, as we discussed in our latest “Capital Topics” podcast.
Investors typically put the odds of a catastrophic crash in the next six months at 10 to 20%, according to a recent Wall Street Journal article titled “Financial Bubbles Happen Less Often Than You Think” by Yale University finance and management studies professor William Goetzmann.
How often do crashes actually occur?
Only on four days since 1887 did the Dow Jones Industrial Average fall more than 10% in a single day (two of those days occurring during the 1929 crash), Goetzmann found.
You read that correctly—four days out of 34,000 trading sessions.
Bubbles are the exception
Goetzmann studied 21 international stock markets from 1900 to 2014 to see how often bubbles occur that end in a crash. He defined a bubble as a rapid doubling of stock prices after which the market gives back all or more of its gains over the next five years.
“Looking at all of those possible five-year periods, bubbles only happened in less than one-half of 1% of them,” he found.
Bubbles stand out in our memories and market histories, but they’re by far the exception, not the rule.
An investor who stuck with a diversified global stock portfolio since 1900 earned a 9.5% annualized return despite the crashes of 1929, 1987 and 2000-02, the financial crisis and the Covid meltdown, Credit Suisse researchers found.
Markets shrugged off wars and crises
“Bubbles loom large in our historical understanding of the financial markets,” Goetzmann wrote.
“[But] one of the biggest mistakes an investor can make is to rely on a handful of colorful historical episodes and ignore the long intervals in between: the sequence of quiet gains that stock markets have made over the decades and centuries they have existed.”
As Warren Buffett put it, “In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.”
Further gains more likely after a boom
But surely, you may ask, is there no reason to be more worried today after the remarkable market melt-up of the past three years?
It turns that booming markets are more likely to continue doing well than giving up their gains. In another study, Goetzmann found that after a stock market rise of at least 100% in a single year, markets doubled again 26.4% of the time in the next five years. Only 15.3% of the time did they give back the entire gain.
“Put simply, boom periods were almost twice as likely to lead to further gains as devastating crashes,” wrote financial journalist Robin Powell, summing up the findings.
Bubbles often spring from real innovations
This makes sense if we remember that multi-year market manias are often fuelled by technological revolutions that transform society and create legitimate value, even if they’re sometimes accompanied by speculative excess.
The infamous South Sea Bubble of 1719-20—often cited as the first big bubble—left behind expanded trade routes and infrastructure. The Roaring Twenties were driven by advances in radio technology and mass production of consumer goods.
The dot-com mania ushered in the internet age—revolutionizing communication, commerce and access to information.
Sitting out can be risky too
On the other hand, trying to time the market to avoid a crash is almost impossible and risks cutting you off from the days with the greatest upside.
Missing the 20 best trading days over a 20-year period typically reduces total returns by approximately 50%, Powell said.
“The most dangerous financial advice sounds perfectly sensible: ‘Don’t lose money,’” he noted. “Generations of investors have followed this wisdom religiously, keeping their savings safe in cash and bonds while waiting for the ‘inevitable’ market crash. They’ve successfully avoided every bubble, every correction, every moment of volatility. They’ve also missed 300 years of wealth creation, making safety the riskiest strategy of all.”
Focus on the long term
Should we do nothing at all then? No. Booming markets are a good time to revisit your portfolio to see if it’s still in line with your target allocations and rebalance if needed.
Should your financial needs or risk tolerance change, consider speaking with an advisor about possible tweaks to your investing strategy.
You can’t know how the market boom will end. But you can cultivate peace of mind by ignoring the daily noise, maintaining a disciplined focus and taking satisfaction in your steady long-term gains.
Find more commentary on personal finance and investing, our podcast, past blog posts, eBooks, model portfolios and market statistics on the website of PWL Capital’s Parkyn-Doyon La Rochelle team and our Capital Topics website.