Tuesday, January 13, 2009

Beware of bubbles

A bubble occurs when market prices are inflated beyond their real values. This has happened with the property market, stock market and more recently, with the commodity market, oil market, China stockmarket and India stockmarket.

All bubbles will lead to a collapse. All the markets mentioned above have collapsed.

Many people may not realise that there is another safe market that is in a bubble. It is the Government bond market. Due to risk aversion, many people put their money in long term Government bonds. The excess demand has pushed up the price and reduce the yield.

If the long term yield for safe Government bonds should be 4% (to cover inflation and cost of money) and excess demand causes the yield to drop to 2%, the price has gone up by about 25% in the case of a 15 year bond. If the yield returns back to the real value of 4%, the price will drop by 20% to get back to the normal level. It is possible to have a bubble in safe investments as well.

If you are caught with long term bonds yielding 2% (and the market price has dropped by 20%, you still have the option of keeping your money at the low yield of 2% for the 15 years).

Lesson: Avoid bubbles. Avoid paying a high price for your investment. Take a long term view.

5 comments:

Jan said...

Hi Mr Tan,
Thank you for yr timely reminder!
My SGS bond, bought 2 yrs ago, will mature on 15 Jan 09, guess i will not put my money into them just yet...
I don't actually know how it works but I do know that interest and yield go separate ways, and the principal is 100% guaranteed.

Anonymous said...

Sell or take profit in a bubble. Do not buy.

Buy when it has deflated.

However, such opportunities don't come often so you must read and seize the timing when it comes.

Anonymous said...

Price is what you pay and value is what you get.

Always compare bond yield and earning yield and knows the risk premium in buying shares.

Anonymous said...

Bubble or no bubble, long-term bonds are bad investments. If you compare the price history of LT bonds and stocks, they're just as volatile. But, LT bonds have low inflation-adjusted real returns whereas stocks real returns are much higher.

It's better to invest short-term funds in short-term government bonds and long-term funds in equities. The short-term funds will provide for liquidity needs and the long-term funds will aim for higher returns with the ability to sit through volatility in the interim.

Anonymous said...

How does one know a bubble is forming.
Are we still having a property bubble now?

Blog Archive