How to avoid being ruined by market bubbles

There's a great story told by US fund manager Jeremy Grantham, which sums up almost everything that's wrong with fund management. Grantham was always sceptical about the technology bubble. He shunned the sector during the mega-boom years of 1998 and 1999. As a result, his funds underperformed, and his company lost a lot of business. About 40% of his clients left and took their money elsewhere.

But he wasn't the only dotcom sceptic. Indeed, at the height of the boom he asked roughly 1,100 "full-time equity professionals" if they thought that a major bear market (where stocks fall heavily) lay ahead. Incredibly, more than 99% of them agreed. This was "even as their spokespeople, with a handful of honourable exceptions, reassured clients that there was no need to worry".

The problem was that clients’ ordinary investors all expected fund managers to be in technology stocks. After all, that's where everyone was making the big money. So fund managers and professionals stuck with them not because they thought technology stocks were good investments, but because it was good for business.

In the end, of course, Grantham was proved right. And by sticking to his guns, he won himself a lot of credibility and respect, which continues to this day.

The moral of the story? That when a fund manager says something is a "good investment", you shouldn't necessarily believe him.

The good news is that you're not a fund manager and you don't have to worry about being fired by your clients. You only need to worry about one thing – your own money. So you can happily sit out bubbles if you think an asset class is ridiculously overvalued.

The bad news is that it's not always easy to spot a bubble. You'll always have people who argue that one asset class or another is in a bubble. 

A simple, practical way to avoid buying overpriced investments

There are many ways to spot bubbles; some are better than others, but none is perfect. And you can never be sure when a bubble you think you've spotted is going to pop.

Apart from the difficulty of spotting bubbles, there's the question of resisting them. It's easy to get overly attached to an asset class, particularly if it has made you a lot of money.

So what is a practical way to overcome your own natural biases? The answer is by using asset allocation and rebalancing. This is where you decide what you want to invest in, and how much of your portfolio to devote to it.

Rebalancing is about keeping your asset allocation on target. Depending on how active you are as an investor, you can do it once every quarter, or once every six months, or once a year. I probably wouldn't leave it much longer than that.

Say you have £100,000 to invest. You decide at the start of the year that it's a good idea to have 5% of your money in gold (£5,000), 30% in bonds (£30,000), 40% in equities (£40,000), and 25% in cash (£25,000). This isn't a recommendation by the way, it's just to give an idea of how rebalancing works. 

By the end of the year, you've had a good year. The total portfolio is worth £110,000. You've got £26,000 in cash. Your gold holding has gone up to £6,000. The bonds section is worth £40,000. Your equities have slid a little in value, falling to £38,000.

So your asset allocation is now 23.6% cash, 5.5% gold, 36% bonds, and 34.5% equities. As long as you still agree with your original asset allocation plan, then you should consider rebalancing. In other words, you'd sell some of your bond holdings and your gold, and use the profits to top up your equity holdings and your cash.

The reason this is a good ideas is that it means that if you are holding a bubble asset, then at least you'll regularly take profits from it and invest them in an asset class that is now out of favour. It's one way to make yourself "buy low" and "sell high".

Of course, you need to get your asset allocation decisions right in the first place, which is something we'll consider in more detail in future.

What to do now

Look at your portfolio again. Is there anything in there that you can only justify holding with an 'it's different this time' argument?

Be particularly wary of long-held, much-loved investments that have made you a lot of money in the past. It's very easy to become attached and hold them beyond their sell-by date. Is it time to revisit your original asset allocation? If not, then do you at least need to rebalance your portfolio?