Outside the Box: How to invest in a market bubble

Should investors be worried that this feels like a bubble? After all, bubbles eventually burst.

Read: It isn’t just GameStop: Here are some other heavily shorted stocks shooting higher

Fund manager Julien Bittel of Pictet Asset Management noted that the U.S. stock market’s total value of $42.6 trillion on Jan. 22 was twice the size of our $21.2 trillion economy. What makes that interesting is that at the peak of the dot-com bubble in March 2000, just before a painful bear market, the market’s total value was 1.4 times the size of the economy back then.

The notion that we’re in a stock market bubble is not exactly a new idea.

Read: How you could lose everything by short-selling stocks

As financial blogger Ben Carlson noted recently, the media has been crying “Bubble” pretty steadily since early 2010, when the S&P 500 was less than half its current level.

A stock-market bubble typically starts when investors fall in love with some new development and possibility, leading investors to pour money into stocks as prices rapidly increase. This often becomes euphoria, with caution thrown to the wind.

Read: How an options-trading frenzy is lifting stocks and stirring fears of a market bubble

But at some point nervous investors start taking profits, forcing prices down. Panic selling can follow quickly as investors rush to the exits.

I have a shorthand description for some of this: the “I can’t stand it anymore” system of market timing. In one case, investors can’t stand to see everybody else making money, so they jump on the bandwagon. In the other case, investors just “can’t stand” to take losses any longer.

This almost always leads to dreadful consequences.

Here are three interesting questions and my quick answers:

• Is the market in a bubble now? It seems like it, but only time will tell for sure.

• Is this bubble about to burst? All I can say is that it hasn’t done so yet.

• Will it burst sometime? Most likely yes, when most investors aren’t expecting it.

The much more useful question is what you should do when the market is in bubble (or near-bubble) territory. The answer isn’t the same for everybody.

I interact with lots of investors, and they tend to fall into five broad groups.

Group 1: The majority of people I regularly speak with believe they are longtime buy-and-hold investors. My advice to them is usually some variation of “Keep doing what you’re doing.” (Of course that assumes they are holding investments that make sense for them.)

John Bogle famously stated this advice: “Don’t do something, just stand there.”

Group 2: Many investors want higher long-term returns and are questioning whether they own the best stocks, asset classes or funds. My advice here is to own 10 asset classes that have favorable long-term records.

On my website you can find this list along with our newly updated best-in-class ETF recommendations.

If the threat of a bubble is a good incentive to “clean house” and upgrade your lifetime portfolio — and if you understand the tax implications of making the necessary trades — then have at it!

Group 3: Young investors and those just getting started. These people are typically setting money aside in their 401(k) or similar retirement programs or in IRA accounts. I think they should ignore bubble warnings and keep adding money — especially when prices decline and each dollar invested buys more assets worth holding for the long-term future.

Group 4: Market timers. I really have no good advice for investors who follow the “I can’t stand it anymore” approach I described above. Fear and greed are awful guides for long-term investors.

But if you are determined to use timing, consider investments that are clearly not in bubble territory. Ben Carlson recently identified a handful of asset classes that fit that description and therefore are presumably priced for buyers:

• Emerging markets.

• European stocks.

• Energy stocks.

• Japanese stocks.

• Value stocks.

• Financial stocks.

If you believe the overall stock market is a bubble in danger of bursting, these could be good alternatives.

Group 5: People who already have enough to meet their needs. This is an excellent position to be in, and logically it should not present a problem.

However, lots of people in this category still want more, more, more. And they’re willing to risk what they already have in order to get that elusive “more.”

I usually argue that this is the time to play defense.

The most effective strategies to defend what you already have are diversifying your equity portfolio and increasing your proportional investments in bond funds.

Recently I spoke with an investor I have known well for some time. A very big part of her portfolio is in a single stock she acquired when she worked for a technology company. If she sold that stock, she would have enough to take care of her needs for the rest of her life.

When I asked her what she wanted most, her first answer was making as much money as she could. I told her she could sell that one stock and buy an equity index fund and still have the same expected return — with much less risk.

After we talked awhile, she came around to the idea of unloading the stock to lock in her gains, knowing she would be set for life. In her case, this seemed like a very sensible approach.

Every personality and every set of circumstances is different. If you struggle with this situation, a good adviser who doesn’t sell products may be a big help.

It’s impossible to know the future, but a good understanding of the past can help you find the best course.

To that end, here’s a podcast and a video that I’ve put together discussing our updated best-in-class recommendations.

Richard Buck contributed to this article.

Paul Merriman and Richard Buck are the authors of We’re Talking Millions! 12 Simple Ways To Supercharge Your Retirement.