Part 2: Applying Rational Discipline in Uncertain Markets
Every investor eventually faces the same question: how do you stay disciplined when a stock market bubble seems to be forming?
In Part 1, we explored a question that never quite leaves the investing conversation: Are we in a bubble?
The answer, as history shows, is rarely clear-cut. Some investors see warning signs in soaring valuations and AI-fuelled enthusiasm. Others see genuine innovation driving earnings growth.
That’s the paradox of markets. Bubbles are only obvious in hindsight.
The definition is subjective, yet the pattern they follow is remarkably consistent. Periods of easy money and optimism inflate expectations until reality (risk-free rates, slower growth, or shifting sentiment) brings them back to earth.
While no one can pinpoint exactly when or how a bubble ends, we can prepare for the possible ways it unfolds. The key is to respond rationally, not react emotionally.
As Howard Coleman once put it: “We will have a crash; I just can’t tell you when, and I can’t tell you how deep.” The goal is not prediction, but preparation.
Three possible paths
Although every cycle is different, bubbles tend to end in one of three ways: they deflate slowly, pop suddenly, or keep inflating longer than expected. Each path demands different investor behaviour, but the same mindset: rational, patient, and grounded in process.
Scenario 1: The Slow Deflation
Some market bubbles unwind gradually. Prices cool, liquidity tightens, and optimism fades — not overnight, but over months or years.
This period is challenging because the change feels subtle. Portfolios drift lower, confidence wanes, and it’s tempting to sell simply to escape discomfort. Instead, investors can use this time to review holdings with two simple questions:
- Would this company’s earnings fall meaningfully in a weaker environment?
- If prices fall, would this business likely decline more or less than others I own?
Separating fundamentals from fear is essential. Companies with recurring revenues, low debt, and pricing power generally fare well. Companies that rely on debt, discretionary spending, or high valuations may need reassessment.
Gradual deflations reward discipline. Avoid overtrading; let valuations reset naturally; and keep dry powder for opportunities that emerge as sentiment normalises.
Scenario 2: The Sudden Pop
Occasionally, bubbles burst quickly. Liquidity evaporates and panic ensues. This is the hardest environment emotionally, yet the simplest intellectually: what’s fragile breaks fastest.
Businesses with excessive debt, thin margins, or speculative valuations on the basis of sales rather than profit can fall hardest. Investors exposed to these names often discover too late that financial leverage is a double-edged sword.
Preparation, not prediction, makes the difference. Careful selection across quality companies and industries provides resilience. Those who enter downturns with manageable exposure and some cash on hand can act when prices detach from value.
Selling purely out of fear is rarely productive; re-allocating towards stronger, undervalued businesses is.
Scenario 3: The Bubble That Keeps Inflating
Perhaps the most psychologically testing situation is when markets continue rising despite every warning light flashing red. Herd behaviour intensifies, and the fear of missing out replaces caution.
In this stage, restraint is the hardest virtue. The prudent investor recognises that rising prices don’t reduce risk — they magnify it. Continue analysing companies with the same discipline as always. If valuation and expected return align, invest confidently; if not, wait.
As Charlie Munger once said, “A good company is not worth an infinite price”.
Patience in euphoric markets is an underrated edge. As history shows, opportunities always return to those willing to hold cash while others chase returns.
Keeping powder dry
Whether bubbles deflate or burst, mispricing always follows. Periods of volatility often create short windows when quality businesses trade at attractive discounts.
Holding some cash — or at least maintaining the capacity to act — is essential. It allows investors to buy not when it feels comfortable, but when it makes sense. Volatility, after all, is not the enemy; it is the mechanism through which patient investors are rewarded.
As one lesson repeated in our member discussions puts it: “Volatility is the friend of the knowledgeable investor.”
The cycle comes full circle
Bubbles are as old as markets themselves. They remind us that emotion, liquidity, and innovation will always intertwine to produce periods of excess followed by opportunity.
Across both parts of this series, one theme stands out: successful investing has little to do with predicting cycles and everything to do with enduring them.
The framework is timeless:
- Own businesses with Wealth Winner qualities.
- Avoid speculation and excessive debt.
- Maintain a margin of safety in both valuation and mindset.
- Treat downturns as opportunities, not threats.
Whether today’s optimism proves to be a bubble or a new phase of innovation, those principles remain unchanged. Markets may bend to emotion, but discipline — and time — remain the great equalisers.
