Avoid the Next Bursting Investment Bubble

Have your personal finances ever gotten clobbered by an asset class bubble?

If your portfolio blew up in 2000 when Internet stocks imploded, or if you bought a home between 2004 and 2006 and now find yourself upside down in your mortgage, you know firsthand the devastating effects of an asset class bubble.

Asset class bubbles defy easy explanation and identification. There is no defining threshold that announces the beginning of effervescent economic conditions, and no easily identifiable tipping point that precedes the inevitable pop.

However, most bubbles share certain characteristics that set boom-and-bust cycles apart from the supply-and-demand dynamics that normally govern most markets.

In his recent book, "Boombustology: Spotting financial bubbles before they burst," Vikram Mansharamani took a multi-disciplinary approach to studying bubbles and identified traits shared by five infamous boom-and-bust cycles.

Watch out for these five signs of an asset class bubble.

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.

Sign No. 2: Easy Credit

One characteristic of nearly all bubbles is the heavy use of leverage "or the use of debt vehicles to fund additional purchases on the expectation that the value will continue to rise and rise," says Rodriguez.

According Mansharamani, three dynamics of easy money can lead to bubbles.

Financial innovation: Financial institutions evolve with the times. When economic conditions are conducive to easy credit and excessive risk, products emerge that enable consumers to borrow too much money. Example: interest-only mortgage loans.

Cheap money: Low interest rates on loans make money cheap. "When I say that money is too cheaply priced, I mean that interest rates are far below where they would naturally occur if you had a freely floating interest rate model rather than one where a central banker sets the interest rates," says Mansharamani.

Moral hazard: When individuals are protected from risk, they behave differently than if they had to live with the consequences. If they can't fail, they take more risks. The same is true of financial institutions and corporations.

Sign No. 3: Confident Consumption

Pride goes before a fall, and hubris is always involved in bubbles. Conspicuous consumption and overconfidence go hand in hand.

"Generally, this overconfidence manifests itself in world records -- for instance, in prices of art and wine or even the world's tallest skyscraper," says Mansharamani.

Technological innovations can also impel investors to believe that this time is different, that the world is fundamentally changed and a new era is underway.

Sign No. 4: Political Manipulation

Another characteristic of past bubbles is the heavy hand of the government reaching in to stir up the free market pot with regulations and price manipulation, according to Mansharamani.

When questioning the presence of an asset class bubble, he suggests investors consider politics.

"Are we seeing the government distort behavior because of tax policies, incentives, ceilings, price floors or subsidies of any sort? And, are we getting moral hazard in the sense that they will protect you if you are failing?" says Mansharamani.

Another characteristic of past bubbles is the heavy hand of the government reaching in to stir up the free market pot with regulations and price manipulation, according to Mansharamani.

When questioning the presence of an asset class bubble, he suggests investors consider politics.

Sign No. 5: Herd Mentality

People can walk on the moon, but following the herd is still irresistible.

"There are a lot of group or herd behaviors where people follow others they believe know what they are doing. Those people don't actually know what they're doing," says Mansharamani.

By the time you realize everyone is falling off the cliff, it may be too late to scramble to safety.

"The classic story that you hear people say -- if the valets and waiters and all the service people around the rich hotels can think of nothing other than what stock to buy, it's probably time to sell," says Rodriguez.

It doesn't help that bubbles often come with compelling stories that can cloud facts, even for the most clear-eyed contrarians.

"It's like in the heyday of the Internet stocks. The narrative was it doesn't matter that they don't have profits now -- they will and don't be late to the party. So it's usually that which gets you," Rodriguez says.

Avoiding Bubbles

Maintaining a diversified portfolio and investing in accordance with a well-thought-out plan will mitigate the damage from a bubble in one asset class. Though nothing is guaranteed, a broad asset allocation strategy across asset classes and geography coupled with regular rebalancing can reduce the risks individual investors face.

"In the absence of cost you should rebalance daily. If you determine the right allocation for you is 60% equities and 40% bonds, why let the market determine what your allocation is?" says Larry Swedroe, director of research at Buckingham Asset Management in St. Louis.

Unfortunately, cost is never absent when trading, in which case Swedroe recommends rebalancing every time new cash is deposited into the account rather than doing it on a quarterly or yearly schedule.

"Time-based rebalancing makes no sense. An alternative is setting up boundaries. For instance, you may have 10 asset classes, each 6%. 'As long as it stays between 5% and 7% I'll let it drift. If it gets out of there I'll act.' You determine what is appropriate, but stay disciplined and stick to it," he says.

Investors could even benefit from bubbles by regularly taking profits off the table and reinvesting in asset classes that aren't doing so well, effectively succeeding at investing by buying low and selling high.