How To Profit From Bubbles

Prior to becoming the Fed chief, Ben Bernanke was the economics department head at Princeton University. During his tenure, a team was formed to study economic bubbles, i.e. why they form, how they collapse, and, interestingly, how to profit from them. The findings of their study are summarized in Bernanke's Bubble Laboratory by Justin Lahart in The Wall Street Journal. Here were my takeaways on why bubbles form and persist from the article:

Optimists dominate. The article concludes bubbles form with developments that potentially have far reaching effects, e.g. automobiles in the twenties and more recently the Internet and finanical innovations, and there are extreme differences in opinions between bullish and bearish investors. However, as the bubble grows, optimists become the dominant investor group.

Pessimists leave the market because they have or expect signficant losses. Being bearish, one can short stocks, buy puts or stay out of the market. As the bubble builds, shorting stocks or buying puts can result in significant losses. Eventually, the pessimists lose enough money and exit from the market, leaving optimists to drive up the market.

Interestingly, the article proposes the best way to profit from a bubble is to participate, and to exit when the bubble has run it's course. According to the article, a major indication of a bubble is that "people pay a crazy price and people trade like crazy." However, there was no mention of a similar indicator for a bubble about the burst. Thus, while recognizing a bubble is possible, exiting before a major downturn may be very hard to do.

While I usually avoid investing in bubbles, I think I'll try to profit from the next one, on a very small scale. To limit potential losses, I will allocate no more than 5% of our savings in a "bubble" investment area. The limit will also serve as a mechanism to lock in gains, since the investment will need to be sold off periodically to keep amount below 5%. In addition, I believe short term (i.e 10 day and 50 day) moving averages can be used to determine when a decline may be happening. By selling when the bubble price crosses below both these moving averages, I think I may be able to get out before a signficant decline. The key will be the ability to emotionally accept selling at a price below the near term high.

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This is not financial or investment advice. Please consult a professional advisor.

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