[Insight & Opinion] How Should We Prepare for the AI Bubble Burst?

Prioritize Diversification and Liquidity Over Prediction
Adjust Asset Allocation to Endure a 10-Year Long-Term Investment

Debate continues over a potential bubble caused by excessive investment in artificial intelligence (AI). In fact, there are still diverging views on how much AI will contribute to economic growth. Even if expectations are not exaggerated, it always takes time for returns on investment to materialize after a new technological revolution emerges.

In many cases, bubbles form not because of the technology itself, but because of expectations that are set too early. When the future is too quickly priced in, a bubble forms, and when reality eventually sets in, the bubble bursts. While such market corrections are inevitable, it is impossible to predict their timing in advance. The volatility index (VKOSPI) in the stock market is simply a numerical reflection of expectations already priced into options.

At the end of 2015, the index was said to be at a risky level, but in reality, the KOSPI rose slightly in both 2015 and 2016. Predicting short-term stock price fluctuations is impossible. You cannot predict the peak, nor can you know the bottom. Rather than trying to forecast when the bubble will burst, it is best to prepare for it.

The method is well known but hard to put into practice: diversify your assets and maintain a certain level of liquidity. Of course, this is easier said than done. While it is advisable to reduce the proportion of risky assets, indiscriminately increasing cash holdings is not the right approach either. Typically, long-term investors keep about 5% to 10% of their portfolio in cash to prepare for corrections. If a sharp market shift is expected, even neutral investors may raise their cash allocation to as much as 30%. Ultimately, the standard for making this decision is how much of a decline you can withstand.

Diversification is also easier said than done. It is often said that to fully eliminate unsystematic risk in the market, you need to invest in more than 20 different stocks. If possible, it is better to avoid investing in individual stocks altogether. If you are unwilling to give up investing in individual stocks, finding defensive stocks, companies with strong financial structures, or those with stable cash flows can help you better withstand volatility.

It is basic to reduce overall portfolio volatility by increasing the proportion of assets with low correlation to stocks, such as bonds or commodities. Of course, the best way to overcome market volatility is to endure for a long time. It is commonly said that the longer the investment period, the lower the risk. But this, too, is not easy. The concept of "long-term" originally means the minimum period required to weather corrections and expect solid returns. It refers to experiencing and enduring at least one full market cycle, which typically takes about four to seven years, from expansion to peak, contraction, and bottom. In other words, you need to get through at least one such cycle.

For this reason, the standard for long-term investment is often set at ten years. Major market corrections usually see the worst pass within two to three years, but it can take five to ten years to recover to previous peaks. After the dot-com bubble burst in the early 2000s, it took more than seven years for the S&P 500 index in the United States to regain its previous high.

It is also said that it takes ten years to confirm a company's long-term competitive advantage. Of course, before that, you should avoid excessive investment through margin trading or loans. Minimizing or avoiding the use of leverage is the first thing to do to prepare for a bubble burst. Completely leaving the market is not advisable. It is easy to miss the rebound and inflation must also be considered. In principle, while investing, you should accept that you will inevitably take some hit from "systematic risk" if a market-wide bubble bursts.

Kim Sangchul, Economic Commentator

This content was produced with the assistance of AI translation services.