How to Survive (and Thrive) in a Bubble Economy: Understanding Bubbles & Investment Strategy

In this week’s edition:

• What is a Bubble

• How does it form

• Understanding the Leverage

• The Investment Strategy

History has a funny way of rhyming.

In the 17th century, a Tulip in the Netherlands sold for as much as a Mansion.

In the late 90s, adding “.com” to your company name magically added $Billions to its value.

Both eras saw a frenzy of speculation drive prices to absurd heights, only to come crashing down. 

Most Investors were left nursing massive financial losses (and bruised egos).

Tulips fizzled out, never to return to the same prominence.
The internet ended up shaping the 21st century.

The formation of Asset Bubbles is a fascinating phenomenon.
It’s as much about human emotions and behavior as it is about Financial Markets.

And while some are harmless enough if you avoid them (NFT bubble of 2021), others threaten to bring down entire economies (US Real Estate Bubble of 2021).

It’s never been more important to understand what Bubbles are, how they form and how to navigate them.

What is a Bubble and what fuels it:

A Bubble is when the price of an asset, such as stocks, bonds, real estate, or commodities, rises massively and rapidly without underlying fundamentals to justify the price spike.

Let’s say a local grocery store makes $10,000 per month in revenue.
You hear someone bought it for $100,000,000.
Without any other details, you’re likely to think that’s a bit … off.

But, throughout history when 3 factors combine Asset Prices do crazy things:

• A hot new trend captures the public (and media’s) imagination.

• The lure of massive profits brings in New investors; many of whom have no idea wtf is going on.

• Easy access to Money and Credit makes it easy for people to borrow money to invest in these hot assets, further fueling the speculative frenzy.

This frenzy can't last forever.

Eventually, reality sets in. Maybe the trend fades, growth slows, or interest rates rise. Suddenly, investors realize the asset is vastly overpriced.

Panic selling ensues.

Everyone wants to get out before the price plummets further.
This mass exodus drives the price down dramatically.
The bubble finally bursts with fortunes decimated.

In just my lifetime, this phenomenon this has repeated multiple times:

-Japanese Asset Price Bubble
-Comic Book Bubble
-Beanie Baby Bubble
-Dot-com Bubble
-U.S. Housing Bubble
-Chinese Stock Market Bubble
-Cryptocurrency Bubble
-SPAC Bubble

And it taught me 3 inconvenient truths about Bubbles:

1. They are inevitable
   

2. They can form anywhere
   

3. It might change the world, but you could still lose a lot of money
   
   The internet shaped the 21st century. Many investors were wiped out investing in the wrong companies.
   Japan is a leading World economy. Its asset prices still haven't recovered.

If you still want to invest in the Hot New Trend: Understand the Leverage

Look, I get it. It’s hard to sit on the sidelines when so much money is being made.

But, the critical mistake people make is they overexpose themselves and end up facing Catastrophic Losses.

They are blinded by the extraordinary potential gains and neglect the (very large) probability that they can lose their entire investment.

The recent Crypto Bubble had many terrible examples of this.
Individuals with small Net worths investing money they can’t afford to lose into a highly volatile asset when the Bubble was nearing its peak.

Even worse, some borrowed money to get more exposure.

So, what’s the strategy ?

One way is the barbell strategy. This involves allocating most of your portfolio to safe, low-risk investments while using a small portion to invest in high-risk, high-reward assets, such as those in a potential bubble.

This allows you to participate in the upside potential of the bubble while limiting your downside risk.

If you have $10,000 in case and invest $500 in a risky asset that ends up 10X’ing, then you’re $5,000. That’s a 50% increase in Net Worth!
If your investment goes to Zero, you lose $500. It hurts, but you’ll survive…
It’s when people get overly greedy that disaster strikes.

Remember: Investing in a bubble is always a gamble.

There's no guarantee that you'll come out ahead, even if you're careful.

However, by understanding leverage and employing strategies like the barbell approach, you can increase your chances of success and protect yourself from the worst-case scenario.

The information contained in this newsletter is for general informational purposes only. It should not be construed as financial or investment advice. Please consult a qualified financial advisor before making any investment decisions.