Strategies for Stock Market Bubbles—Or Anytime

When the stock market hits highs several times in a relatively short period, investors can wonder about a potential bubble. While many professionals say conditions are different today than during previous bubbles, financial consultants Melissa Ohler and Addison Schubert discuss strategies to consider if you're concerned about a bubble.

What Is a Stock Market Bubble?

Stock market bubbles can make investors uneasy because as much as the bubble may give you results on the way up; its fate is to ultimately burst. And that's the uncomfortable part.

"Volatility is why clients worry about a stock market bubble," says Addison. "Not too many people fear a rise in stock values, especially if they're earning money. But when they continue to rise and gain a lot of attention, investors fear the drop." This phenomenon in investing is known as loss aversion—no one wants to lose money.

Melissa agrees. "It's all about your perspective and what's happening in the markets at the time." Investors with a balanced mix of investments can think their portfolio isn't risky enough during market rises. Conversely, they can think it's too risky when markets drop.

Market volatility is also one reason we believe in active management. "Active portfolio managers don't just follow trends of the day," says Addison. "They can look at the actual financials of a company and determine whether purchasing its stock is worth the risk."

Stock Market Bubble—What Are the Signs?

Most financial professionals today believe the stock market is not in a bubble, even with higher-than-typical stock market valuations. That's because, unlike the dot-com bubble in 2000, successful companies now have financials to back up their profits. During the dot-com bubble, the opposite was true.

At that time, many people invested in anything related to the Internet, including startups and companies with no real record of profitability.²

3 Potential Signs of a Bubble Brewing

Another thing that may tip off a stock market bubble is that the "trend" has captured the hearts and minds of investors and the new media. "In this way," says Melissa, "A stock market bubble can seem speculative and almost contagious." She says a bubble can be driven by FOMO behavior (i.e., the fear of missing out) when investors fear that the next big thing will pass them by.

"If hype is driving up a stock's price and not its profits based on strong financial statements, you may be looking at a bubble," says Addison.

Some investors want to take advantage of the opportunity during high stock performance. "Although that could mean purchasing a stock at a higher price that you might have been able to buy six months or a year ago, it's understandable to want to get in," says Addison. "But I never discourage people from wanting to invest—because more time in the markets may help you be more successful at reaching your goals."

And, depending on your circumstances and timeline for needing your money, it might be better than sitting on the sidelines, as some are prone to do when the markets seem unpredictable. Jumping out of the markets during volatility could have you missing out on potential recoveries when the markets come back, as they have historically done.

3 Strategies for Bubble Markets

Whether you're wondering if the stock market is currently in a bubble or you fear you'll miss out on an opportunity, our consultants say time-tested strategies can help you during market ups and downs. Here are their top three:

1. Know Your Risk Tolerance

Your risk tolerance tells you how much risk you are willing to take, and it's essential to "know yourself" when choosing your investments. "Having the right amount of risk for you can help you stick with your investment plan when the going gets tough," says Melissa.

She says most investors have a good idea of where they fall on the risk spectrum—from conservative to aggressive—and your tolerance can change over the years.

"Clients generally understand that they can take on more risk when they're younger because they have more time to recover if a bubble should burst or markets in general should drop." Investors who are closer to their goals—like retirement—usually want less risk. At that point, they want to protect what they have, and there's little time to recover from losses.

Addison agrees. "I have many risk conversations with clients who have invested in aggressive funds for years. For many, it comes down to balancing risk and rewards and what they would do if the market pulled back 20%. Can they live with the drop?"

He, too, says a person's tolerance for risk depends on where they are in their timeline and their overall financial picture. "There are so many variables that can come into play, but knowing what you can handle is essential for your investment plan."

2. Stay Diversified

Along with knowing your risk tolerance, you need to use different kinds of investments in your portfolio. Diversifying means you include various asset classes, including value and growth stocks, domestic and international stocks, different-sized companies, fixed-income investments and cash equivalents.

"Spreading out your investments over several types of assets can help balance out your portfolio when markets move up and down," says Melissa. That means when there's a loss in one area of the market, you have the potential to have a gain from another part. "That balance is the goal."

Addison agrees, "If you already have a diversified portfolio, you may understand better how it can work firsthand." Seeing losses and gains offset each other can help you understand why we are strong advocates for diversification. It can be a very different picture if the markets fall—or a bubble bursts—when you're invested in all one kind of asset.

Both consultants agree that a key is to understand what diversification is. It means having different types of investments that won't all react the same way during a market event.

3. Stay Invested

It's human nature to want to avoid stock market losses. However, jumping in and out of the markets has not been a successful strategy for investors in the past. Even missing 10 of the market's best days can impact how much your investments may grow over time.

"Trying to time the markets doesn't work well," says Addison. And it can also lower your returns. "You really have to time the market twice—when you're getting out and getting back in. At that point, I like to review a client's goals and see where they want to be. Often, they can see that sitting on the sidelines won't get them the results they need."

How can you stay invested when feeling the stress of market volatility or potential fears of a stock market bubble? Besides having that well-diversified investment plan that fits your risk tolerance, our consultants say to avoid the headlines, especially if they make you nervous. Staying away from market news that makes you anxious or hypes you up could help you avoid making bad decisions for your future. And it's one step in helping you avoid emotional investing decisions.

Melissa recommends, "Stick to your plan and avoid the media hoopla. It also may help to speak with a financial professional to get perspective on what's happening in the markets and how you can potentially invest the best way for you and your goals."