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Avoid the next bursting investment bubble

Sign No. 1: mispriced assets
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Sign No. 1: mispriced assets

The first trait is a glitch in the mechanism for setting prices. After all, the most obvious characteristic of bubbles is skyrocketing prices apropos of nothing.

In a free market where the forces of supply and demand set the price of an asset, prices tend toward an equilibrium between what someone is willing to pay for something and the price at which someone else is willing to sell it.

But in bubbles, increased prices produce more demand, which sends prices far above the inherent value of the asset.

For example, investors commonly use valuation ratios to determine if stocks are cheap or expensive.

"For stocks of a particular type of firm in a particular industry, there is typically a ratio or boundary of ratios that seem reasonable or in line with the fundamental value," says Peter Rodriguez, associate professor of business administration and director of the Center for Global Initiatives at the Darden School of Business at the University of Virginia.

When an entire industry or group breaks out of that range, it can be indicative of bubbly conditions.

Determining the value of assets is not always so straightforward. The more esoteric or exotic the investment, the more easily valuation lines are blurred. Internet stocks in the 1990s blurred that line, as do emerging markets stocks from time to time.


 

 

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