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Protect Your Investments Against a Bubble, Know What Makes a Bubble

Stocks in this article: IBB GILD AMGN NFLX SPY

Any industry, including biotech, will rotate in and out of favor relative to a broad benchmark like the S&P 500. This year biotech is ahead of SPY, in 2009 biotech lagged far behind the broad market. This is normal market behavior and the next time the stock market falls a lot there will be sectors and industries that fall more than the overall market and some that fall less. The ones that fall more, maybe biotech, won't necessarily have been bubbles.

Bubbles are psychological events. Internet companies were going change the world in the future and so investors adopted a willingness to value those companies on non-traditional metrics, most notably eyeballs and investors were willing to speculate on them for fear of missing out.

The housing bubble was similar. Loans were being granted on less stringent requirements and people became far more willing to speculate on house flipping and were able to learn how to flip house thanks to a deluge of TV programs on cable TV.

During the Internet bubble, investors came to expect compound annual growth rates of 20% to 30% and in defending the housing market six years ago many serious analysts pointed out that there had never been a national decline in housing prices. Both sentiments were transformational shifts in psychology and both had severe consequences.

True bubbles are always obvious in hindsight but are difficult to detect during their build up. Instead of trying to find the next bubble investors would be better served to manage the risk they take in their portfolios by never allocating more than 20% to any one sector, more than 10% to any one foreign country or more than 5% to any single stock.

Additionally, remaining disciplined to your investment strategy during times of market turmoil is crucial. When the stock market goes down a lot it eventually comes back. After the tech wreck it took seven years and after the financial crisis it took five years but it came back. The people most damaged were the ones who sold after the large declines. There is no strategy planned out ahead of time that calls for selling after large declines. The people who remained disciplined, who did not panic were not permanently damaged by either bubble.

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