How to avoid being ruined by market bubbles

There’s a great story told by US fund manager Jeremy Grantham. It 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.

Some swear blind that gold is in a bubble – and have done ever since it rose to $300 an ounce. Others argue that China can still reflate and breathe life back into industrial metals prices, even although it seems obvious to many others that it can’t.

A simple, practical way to avoid buying overpriced investments

There are many ways to ‘spot’ bubbles, some 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. We’ve already talked about asset allocation. 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.

Here’s why this is a good idea. 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?

Your homework: here’s the answer

If you remember, in the last article we asked you: Kazakhmys is a mining stock. At the time of writing, it trades on an historic p/e of four. Fresnillo is also a mining stock. But it trades on an historic p/e of 25.

What does this say about investor expectations for the two companies? And why do you think the p/e ratios are at these such different levels, even although they’re both miners?

So what’s the answer? Well, the low p/e ratio for Kazakhmys suggests that investors believe its earnings are going to fall. Otherwise they’d be willing to pay more for the stock.

It also suggests that investors think that Fresnillo’s earnings are going to grow strongly (otherwise they wouldn’t be willing to pay so much per pound of today’s earnings).

So why is this the case, given that they’re both miners? There could be any number of company-specific reasons. But the main answer is that Kazakhmys mines for industrial metals. The price of industrial metals is falling, hence the threat to Kazakhmys’s earnings.

Fresnillo, on the other hand, is the world’s largest silver producer (and it also throws off a bit of gold here and there). Investors are optimistic on the outlook for precious metals prices, which is why they also expect the earnings of precious metals miners to rise.

• This article is taken from our beginners’ guide to investing, MoneyWeek Basics. Everything you need to know about how to invest your money for profit, delivered FREE to your inbox, twice a week. Sign up to MoneyWeek Basics here