Bubbles are a fact of life when it comes to investing, but how can we identify them and protect our exchange traded fund (ETF) portfolios from them when they burst?

So exactly how does an investment bubble form? Miranda Marquit for Banks.com says that basically, a bubble is an upward movement that takes the price of an investment well above what might be reasonable when the fundamentals are considered. Think oil prices and commodities or real estate, in recent memory.

It basically results when everyone wants to buy one particular investment, or class of investments. Since there is so much demand and buying of the investment, the price skyrockets.

There’s no way to get away from bubbles. For hundreds of years, there have been manias of all types, and they will continue again and again.

There are two major drivers of bubbles are:

• Investment Fundamentals: These get things going, and the investment class starts to move upward and gain in value. There is demand for the investment, and there is a reason that people value it. If buyers keep coming and the confidence is proven, the price moves upward, building the bubble.
• Human Emotion: Exaggeration of the value of the investment is part of the human element.This occurs when the price begins to spiral out-of-control. Everyone wants in because they want to buy now, before the prices go even higher. Of course, in a bubble situation only a few actually make money in this way, selling just before the bubble bursts.

The only way to protect yourself from bubbles is to have a strategy. By watching the trend lines, you can take a position when there’s an uptrend (evidenced by the crossing of the 200-day moving average). As a mania begins to fade, an exit strategy will help you get out in time and preserve any gains to may have made as well as help protect you on the downside. We use a stop-loss of 8% off the high or when a position dips below its long-term trend line, whichever comes first.

Tags: ETF 101