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How to navigate stock market bubbles

We take a look at what stock market bubbles are, and how investors can navigate them.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Emilia Booth
Investment Writer

Published on 24 November 2021

This article is more than 6 months old

It was correct at the time of publishing. Our views and any references to tax, investment and pension rules may have changed since then.

We all expect to see stock markets move up and down – no one is ever on top for too long. But throughout 2021, we’ve seen countless headlines about different stock markets around the globe reaching all-time highs. The US stock market has had more than 50 new highs so far in 2021 alone.

Most of us will be pleased to see a quick bounce back after the pandemic. However, it’s worth keeping a close eye on recoveries like these to make sure prices and valuations aren’t getting too out of hand.

We’ve looked at what we can learn from the past when it comes to potential stock market bubbles, and how to navigate them. We’re not saying we’re in one, or heading towards one, but it’s worth knowing what to look for.

This article isn’t personal advice. All investments can rise as well as fall in value, so you could get back less than you invest. If you’re not sure if an investment is right for you, ask for financial advice.

Who blows the bubble?

Every bubble is unique, but there are some classic signs one could be brewing.

Stock market bubbles happen when share prices continue to climb, eventually becoming overvalued. That means people are willing to pay above what an investment’s worth, based on things like earnings, revenue, or growth potential.

How to value shares – using different ratios to improve your analysis

Bubbles can also be born from changes to an economy. Low interest rates, like we’ve for the last decade, can persuade more people to save less and invest more. Or, when central banks, like the Bank of England or Federal Reserve in the US, introduce new money to an economy. Both can inflate market prices.

Headlines and investor sentiment all play a part in shaping how the market looks on a day-to-day basis too – markets are volatile over the short term.

If speculators continue to invest in a company or sector believing its value will increase in the short term, it can cause the price to go up.

One of the biggest fears as an investor is the fear of missing out – with fast paced and sometimes volatile markets, it can quickly feel like there’s a lot to miss out on.

During times like these, good discipline and investing principles like thinking long term can go out the window.

It’s important to remember that while you can’t control the market, you can control your reaction to any ups and downs.

Why investing is a test of mind over matter

Bubbles from the past

There have been numerous bubbles in the past. One of the most well-known is the dotcom bubble. Tech, e-commerce, and telecoms companies were going to change the world and people were willing to pay anything to be part of it.

The US tech focussed NASDAQ index soared 86% in 1999 and average valuations reached 170 times earnings in November that year. At one point Yahoo was worth more than General Motors and Ford put together – people were willing to pay 1,000 times the next year’s earnings.

Revolutionary ideas and promises of future earnings growth were plenty. But actual profits or ways to make them were often lacking. Promise alone doesn’t make a solid foundation for investments and many learned this the hard way.

Ultimately, there were some good ideas in the mix – Amazon was one of them. But at the time, the winning companies and technologies weren’t clear – it was set up like everyone was going to win.

When thinking about which new companies or themes to invest in, we think it’s best to wait until potential winners are clearer.

What can we learn from past bubbles?

Some investments look as though they’ve climbed high because they’re just catching up with their pre-pandemic prices. So, their valuations aren’t far off.

For others though, it hasn’t been uncommon to see sky-high valuations, whatever the weather.

There’s not one sole story that’s fuelled investors’ imaginations for the next big thing, like the internet causing the dotcom bubble. But there are still some sectors to err on the side of caution with.

Certain technological advances have been making headlines. From self-driving cars and electric vehicles, to cryptocurrencies – they all seem to offer the promise of a revolutionary future. And lots of investors are jumping into these promises for high prices.

Some promises could come right. But chances are, if an investment or trend has got everyone talking, it might be time to look elsewhere.

Remember, past performance isn’t a guide to the future.

Two common investing mistakes to avoid

What should investors do?

Bubbles can sometimes be hard to spot, and by the time you do notice it, it can be too late.

That’s why it’s essential to build a diversified portfolio. By diversifying, you spread your money between different types of investments, sectors, and parts of the world. This helps spread risk.

For example, if one sector is soaring, it could pay to look at sectors not on every investors’ radar. That’s not to say it might not be painful to watch if markets do take a tumble – bubbles in one stock market can still be felt in other markets too. But top performers usually come in waves, so its best to hold a mix.

Diversification – starting to think strategically

If you’ve built a well-diversified portfolio and now think you could have too much in one area or part of it could be overvalued, this could be a perfect opportunity to review and rebalance your portfolio.

Rebalancing restores the original weightings of the investments in your portfolio.

Suppose you decided to make your portfolio 50% shares and 50% bonds – we’re not suggesting this is the right mix, it just keeps the maths easy for this example.

If your shares happened to grow at a faster rate than your bonds, your portfolio weighting in shares would go above 50%, making your portfolio riskier than when you set out.

To help, you could consider selling a portion of your investments that have done well, to top up investments that have performed poorly. It might sound counterproductive, but as top performers usually come in waves, it’ll help bring your portfolio back into kilter.

Reviewing your investment portfolio

To see how and where your money is invested, log into your HL account and use our portfolio analysis tool.

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