Identifying Investment Bubbles: How to Exit Before the Music Stops?

Investment Bubbles: How to Exit Before They Burst?

Investment bubble refers to the situation where the price of some assets is significantly higher than their actual value, which is usually caused by market speculation and over-optimism. In this case, asset prices will rise rapidly, attracting more investors to join in and forming a speculative frenzy, eventually leading to a collapse of asset prices and a market crash.

This bubble may bring huge profits, but it may also result in huge losses. Being able to identify bubbles may have a huge impact on your investment decisions and portfolio.

What are the characteristics of a bubble?

  • Rapid price rise

The characteristic of a bubble is that asset prices have experienced a very large growth in a relatively short period of time. The rise in asset prices is not in line with the economic laws of the fundamentals, and this price rise is usually driven by speculative purchases by people. As prices rise, more and more people will have a strong urge to buy, and eventually asset prices far exceed their actual value.

During a bubble, market participants generally believe that the trend of rising prices will continue. Investors are overly optimistic and selectively ignore investment-related risks. A large number of investors flood into the market, exacerbating the rise in asset prices.

LUNA is one of the most representative cases. It was considered to have a ‘perfect’ operational mechanism when it was launched, and its founder: Do Kwon had a huge influence. Investing in Luna series products also has a fixed annualized yield of 12%, and related tokens will bring other ‘certain’ returns.

This makes people believe that under all these factors, the price will continue to soar, but it was eventually proved to be a huge investment bubble.

How to identify investment bubbles?

  • Sudden increase in trading volume and liquidity

The emergence of bubbles also accompanies an increase in trading volume and liquidity, because investors rush to buy assets and hope to profit from further price increases.

This surge in trading activity often accompanies a decrease in market depth. When trading volume surges in a short period of time, we need to consider the risk of a financial bubble.

  • Excessive leverage and debt

Bubbles are often driven by increasing loans and higher leverage ratios.

As prices continue to rise, many investors may use loans and take on significant debt to invest, hoping to increase their returns, but also increasing the risk of significant losses when the bubble bursts.

When the bubble bursts, investors may face massive losses because they used too much borrowing or took on too much debt to invest, which makes their losses even more severe. Therefore, excessive leverage and debt are an important factor in bubble formation.

During the Bitcoin bubble in 2017, the number of people using leverage and taking on debt increased significantly.

Many investors used stock loans, credit cards, traditional loans and other methods to expand their investments.

These phenomena indicate that there is a bubble in the market, and it may be about to burst, which is often a clear sign of identifying a bubble that is about to burst.

  • Extensive media coverage

Financial bubbles attract a lot of media coverage, further promoting public attention and participation in the market.

This phenomenon, through the creation of hype and speculation, contributes to the formation of bubbles.

Media attention and public participation are important factors in bubble formation.

In the 2017 bull market, John McAfee made two statements:

  • “The price of Bitcoin will reach $500,000 by 2020”;
  • “Under the new technology of blockchain, data analysis shows that there is currently no bubble”.

These remarks attracted many people at the time, but were ultimately proven to be an investment bubble trap.

  • Warning signals

Among market participants and analysts, there may be a few people who express concerns or doubts about the sustainability of price increases and fundamentals.

During the peak of a bubble, warning signals are often ignored and refuted by most people. Warning signals are one of the important factors in identifying a bubble.

Three development stages of financial bubbles

Bubbles are generally formed in five stages:

  1. Triggering period

  2. Prosperity period

  3. Expansion period

  4. Profit period

  5. Panic period

These stages match the characteristics of bubbles, which further help us discover potential bubbles.

  • Triggering period

Investors develop a passion for new technologies or narratives, especially when the current market sentiment is favorable. In the past cryptocurrency market, technologies such as artificial intelligence and metaverse have triggered such a fever, providing people with “reasons” to invest, thus promoting market prosperity.

  • Prosperity period

In the first stage, prices rise slowly and then reach a point where they start to accelerate. This accelerating trend attracts more and more new buyers and retail investors into the market, and the prosperity period is a critical period for attracting new buyers and retail investors.

  • Expansion period

The number of people sucked into rising assets grows at an unimaginable rate. This leads to prices expanding to extremely high levels, while media reports create new analyses and evaluations to “prove” this significant rise, exacerbating market prosperity.

  • Profit period

This stage is when smart money sells their positions and begins to pay attention to “bubble burst signals.”

  • Panic period

Panic is of course the last stage, where people expect the market to “reload” and erupt again. In this stage, investors see market prices falling and are uncertain when they will rebound, feeling panic and anxiety, and starting to enter a death spiral. When confidence weakens, the bubble bursts, and asset prices drop rapidly and significantly, usually referred to as a “market correction.” Market correction is a self-correcting mechanism that can clear overvaluation and unreasonable prices in the market and restore normal market operation after the bubble bursts. Therefore, bubble bursts and market corrections are inevitable processes in market economies.

Before deciding to invest, we need to ask ourselves a few questions?

  • Is this asset really worth investing in?

  • Does it have an actual product?

  • What stage of development is it in? (final product or test product)

  • What is the market sentiment associated with the asset, that is, the market’s view and expectations of the asset?

Remember, bubbles often last longer than expected, and timing can be very difficult. As an investor, you should be able to identify potential risks and opportunities, such as market hype, intrinsic value of assets, and price behavior stages. These factors may have a significant impact on the performance of the asset. Finally, investors should remain calm and not be swayed by market sentiment to avoid losses when the market bubble bursts.