Jason Zweig in the WSJ this past weekend asks whether it is possible to spot a bubble?  Maybe the better question is if you do spot a bubble what should you do about it?  Zweig is rightfully skeptical that bubble spotting is an easy endeavor.  Therefore some humility is warranted.  He writes:

The great value investor Benjamin Graham suggested that investors should never have less than 25% or more than 75% of their money in stocks. He argued for reducing the allocation to stocks “when in the judgment of the investor the market level has become dangerously high.” But, because no one can perfectly predict a bubble, you should never go either to zero or 100%.

Another point worth noting here is that a search for bubbles, or other abnormal markets, can distract a long-term investor from their overall investment strategy.  A well-formulated investment strategy already takes into account the fact that markets can, for extended periods of time, diverge from fair value.  James Picerno at the Capital Spectator writes:

 It’s easy to get caught up in chatter about when and where the next bubble will pop, but there are more productive ways to oversee assets. Broad diversification, rebalancing and maintaining a contrarian mindset are a powerful mix. Let someone else decide if there’s another bubble lurking. And if they insist on telling you otherwise, ask to see their (audited) performance results that present returns in a risk-adjusted context.

The problem is that many investors have a very limited appetite for underperformance.  In fact this underperformance is inherent in every investment strategy.  Ask any investor who was skeptical of the Internet bubble.  They likely experienced months if not years of underperformance waiting for the mania to end.

Investors who jump from strategy to strategy in search of ever better returns are likely to fall prey to the behavior gap.  One could argue that the ability to stick a well-defined investment strategy through periods of underperformance is an important manager trait.  In an interview with Mina Kimes at Fortune, Jeremy DeGroot notes how he uses performance data to analyze manger performance:

But there’s a real danger in relying on performance — it’s just a starting point. We also look at their willingness to underperform over short or medium time periods if their process is out of favor. We look at whether they’re sticking to what they know and believe in and what has been successful over time.

Mick Weinstein at Covestor notes that a manager has to have a clearly stated strategy.  In short, you can’t stick to a strategy that is not well-defined in the first place:

In the end, a manager and strategy are worthy of your consideration if they have the integrity to clearly define their strategy – what it is and what it isn’t – and stick to it through thick and thin. And it’s the thin periods that make this most evident.

That is in the end the challenge of bubbles and their mirror image: busts. Bubbles upend our expectations about our investment strategies.  Bubbles introduce fear, uncertainty and doubt that we are doing the right thing in the face of underpeformance.  They cause us to chase the hot strategy often to our own detriment.  Provided you aren’t on margin it isn’t the bubble that ends up hurting investors the most.  In the end it is investor reactions to, and the search for, bubbles that can do the most damage.

Items mentioned above:

Can you spot a bubble?  (WSJ)

Don’t get too caught up searching for bubbles.  (Capital Spectator)

[earlier] The behavior gap illustrated.  (Abnormal Returns)

Jeremy DeGroot of Litman Gregory on how to pick fund managers.  (Fortune)

How willing are you to underperform?  (Covestor)