The term “toppy” is frequently used by financial journalists to convey a market which seems to be trading at its high. In this article we talk about what a toppy market it and the strategies that can be implemented to reduce risk in this kind of market.

Definition

A toppy market occurs when the market has hit a level where market looks like it can’t extend from. There may be market sentiment that there is an asset bubble forming. Investors are concerned with toppy markets as there is a risk the market will pullback after it hits a new high as the market does not have enough strength to sustain that level.

What causes markets to be toppy?

Markets become toppy because of easy credit. When interest rates are low, investors can borrow money easily to invest. Asset bubbles are formed when the value becomes higher than what the fundamental data indicate. Investors who see the price appreciation may have the fear of missing out and are willing to pay extra for the asset which causes the price to head up even higher.

What causes asset bubbles to pop?

An asset bubble may pop if central banks look to hike up rates aggressively. If the economic data shows weakening, then this can impact the sentiment in the market and investors may look to sell out. Also, if governments look to reduce spending on stimulus packages, then this may also cause the bubble to burst.

Risk to mitigate a toppy market

Diversification – We previously wrote about diversification and how it can be used a method to mitigate risk. Portfolios which are concentrated in particular stocks or particular sectors can  be riskier than portfolios which are more diversified. For more information clock on the link “What is the optimal diversification for your portfolio?”.

Move to cash – If investors are feeling nervous about the market being too toppy, they can always move into cash to protect their capital. Investors should think about getting out of high beta or high-risk stocks when the market looks toppy or vulnerable for a correction.

Use stop losses – Investors could use a define stop loss level when taking a position in a trade and robotically exit the position when the share price hits that level.

Lauren Hua is a private client adviser at Fairmont Equities.

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