Are you looking for an investment to attain long term financial goals? Do you have the capacity to stay with your investment for the long term? You may invest in stocks and equity mutual funds for inflation-beating returns. However, you must pay attention to stock market bubbles if you want to preserve your wealth.
If the stock price rises exponentially over time, well more than its actual or intrinsic value, then it’s called a stock market bubble. You will lose money when the bubble pops, and the stock price crashes. How to protect your wealth from stock market bubbles?
What is a stock market bubble?
Stock market bubbles are formed when the stock price accelerates far more than its intrinsic value. For instance, intrinsic value is the actual value of a stock determined through the monetary benefit you expect from it in the future.
People are willing to pay a lot of money for the stock, which pushes its price way beyond its actual value. For example, the true value of a stock depends on the company’s earnings, corporate governance, and so-called company fundamentals. However, if the stock price rises rapidly even though the company has weak fundamentals, it leads to a stock market bubble.
Irrational exuberance can fuel the rise in the price of a stock way beyond its fundamentals. Finally, the surge in the stock price turns out too good to be true, and the stock crashes as investors exit their holdings in panic. The stock market bubble has burst, and investors who failed to exit at the right time are left with huge losses.
What causes stock market bubbles?
Flimsy reasons may cause stock market bubbles. For instance, a top stock market analyst may upgrade a recommendation on a particular stock. It attracts the attention of several investors who turn bullish on this stock.
Moreover, news reports, rumours, and significant investor purchases may further fuel a price rise. Eventually, investors realise that the stock prices have run far ahead of their fundamentals. A prominent stockbroker may give a sell call, and investors will exit in panic.
How can you recognise a stock market bubble? A stock market bubble is formed when the stock price exceeds its fundamentals, such as revenue, profits, etc. Moreover, if the stock price is higher than its highest historical value, it could signify a mature stock market bubble that is ready to burst.
How To Protect Your Wealth From Stock Market Bubbles?
You will lose money if you fail to spot a stock market bubble in time. Moreover, first-time investors in the stock market are vulnerable to these market bubbles. You must do your research and study the company fundamentals such as revenue, profits, corporate governance, debt on the balance sheet and ratios such as return on equity and return on capital employed to determine if the stock price justifies its fundamentals.
You must be cautious when investing in stocks that have seen a continuous rise in prices. If you spot excessive demand for a firm’s shares without a corresponding change in company fundamentals, consider this as a red flag. It helps to preserve your existing wealth rather than chase stock market gains through speculation, which can be a wealth destroyer.
You must invest in stocks of profitable companies which have shown continuous growth over time. It helps to steer clear of hot tips, rumours or market noise and avoid chasing excessive gains if you want to protect your wealth. In a nutshell, invest in stocks whose business you understand and invest as a company’s part-owner and not for short term gains.
For any clarifications/feedback on the topic, please contact the writer at cleyon.dsouza@cleartax.in
I write to make complicated financial topics, simple. Writing is my passion and I believe if you find the right words, it’s simple.
