When the bubble “pops,” rates eventually reach a ceiling and then plummet dramatically. Aside from stocks, bubbles can occur in a variety of assets, including real estate, collectibles, commodities, and cryptocurrencies.
What causes a stock market bubble?
Pure optimism fuels a stock market bubble. When the price of an asset starts to rise at a rate that far exceeds its intrinsic value, a bubble begins to form. That people are willing to pay increasingly higher prices for a security or other commodity, over and above what is predicted based on factors such as demand, earnings, sales, or growth potential.
Former Federal Reserve Chair Alan Greenspan coined the term “irrational exuberance” to describe the collective excitement among traders and investors that fuels rapidly rising prices that outstrip underlying fundamentals.
Whether you name it herd mentality, herd bias, the bandwagon effect, or FOMO, there is a self-reinforcing loop in which people want to purchase an asset because its price is rising, which drives the price even higher and makes even more people want to buy it.
It’s important to note that not all price accelerations are bubbles. It’s common for asset prices to rise sharply after a recession or bear market, for example. Although optimism and anticipation can also drive the rebound—namely, that the worst of the market declines or an economic recession has passed—the main difference is that these price rises may be supported by fundamentals in the end.
The different stages of a bubble
Stock market bubbles usually go through the same five phases, which were first described by American economist Hyman Minsky:
A big change, or a series of changes, impacts how investors think about markets in the early stages of a bubble. This paradigm shift may be caused by a major event or breakthrough that causes people to adjust their expectations for the asset in question, with good intentions.
Price increases during the displacement period, but things really pick up during the second stage of a bubble. When news of the asset’s gains spreads, the boom period attracts speculators, who help push the price of the asset higher.
When the asset’s price soars, the fervor grows ever stronger. People are more motivated by enthusiasm than sound justification for the massive price increase during the peak euphoria stage. And, since new investors are eager to join, there’s a feeling that someone will always be able to pay more for the asset.
This can make it seem as if there’s no way you’ll lose money regardless of when you invest. During periods of euphoria, investors have thrown caution to the wind in search of what seems to be a too-good-to-be-true way to become wealthy quickly.
Taking a Profit
Inevitably, the price increase proves to be too good to be true. Booms are followed by busts, and as the bubble reaches the profit-taking stage, some people begin selling to lock in profits. The bubble has burst, and those who know the warning signs will profit sooner rather than later.
Although some late-comers to the game may have held out in the past, hoping that an asset’s price will rise again, by the time the bubble hits its panic point, this is no longer a viable option. Instead, the zeal to acquire an asset has given way to a panic to sell it. The price drop wipes out profits rapidly and promotes more panic-driven selling.
Economic Bubbles: Examples
People always point to any sudden price rise as a potential bubble, but these occurrences are much more rare than you would think. The following are some well-known bubbles:
Tulipmania is an overabundance of tulips. Tulipmania, the mother of all bubbles, erupted in Holland in the 1630s, when the price of Dutch tulips skyrocketed well beyond their value. Just a few months later, tulip prices plummeted, with the flowers finally selling for a fraction of their peak prices.
The South Sea Company is a British company that operates in the South Pacific The South Sea Company’s stock price soared in a matter of months amid excitement about the possible gains from a trade monopoly in the 1720s, only to crash, resulting in an economic downturn.
The dot-com craze. Many Internet-focused companies filed for initial public offerings in the late 1990s (IPOs). Many investors were willing to invest in the then-new and quickly growing internet industry, including in shares of companies that didn’t prove to have viable business models, such as Pets.com, which liquidated less than a year after going public.
Day trading became a full-time career for others, and the S&P 500 index more than doubled in value in just a few years. However, as a result of the failure of a few small firms, the stock market as a whole crashed.
The housing bubble in the United States. By the mid-2000s, a housing bubble had developed in the United States, owing to a rapid increase in house prices. Speculators started flipping houses in the hopes of making a profit, and the average price of a home in the United States rose by nearly 80% between 2000 and 2006.
People who couldn’t afford houses, on the other hand, were renting, and the housing bubble finally exploded. Housing prices took about ten years to completely recover.
What causes a bubble in assets?
The early stages of a bubble may appear to be harmless. For example, a Wall Street analyst can upgrade a stock’s recommendation, which attracts the attention of investors, who become more bullish as a result. Speculative fervor may also be sparked by rumors, a prominent investor, news stories, or knowledge exchanged online or on social media.
What causes asset bubbles to burst?
When expectations change dramatically, an asset bubble bursts. A popular market participant, for example, may sour the mood. Alternatively, the bubble could burst as a result of selling activity that makes investors anxious, triggering fear and a rush to sell the asset as soon as possible—resulting in further price declines.
Although market participants may try to contain both the sudden rise and fall in prices that occur during a bubble, there isn’t anything they can do but advise caution. The Securities and Exchange Commission (SEC) of the United States has a policy in place to ban trading activity in individual assets during major drops or times of high volatility in order to give the market a chance to calm down.
How to spot a financial bubble
It’s tempting to label anything as a bubble when the price is skyrocketing, but it’s actually difficult to do so before the bubble has burst. Not all speculative behavior that leads to price rises results in a shift in expectation that causes the price to fall.
Even then, symptoms of a bubble can be identified when the price of an asset increases beyond and above its fundamental value. It may be possible to detect an economic bubble in its early stages by detecting behavior that corresponds to the early stages of a bubble, but it is difficult to predict whether and when prices will inevitably fall.
How to make money investing in a stock market bubble
Since speculative conduct is at the root of bubbles, the associated practice falls more into the domain of day trading than long-term investing. Even so, you can unintentionally become engulfed in a bubble.
The housing bubble of the mid-2000s, for example, impacted homeowners of all sorts, including those who purchased or sold while prices were rising and those who stayed put as the bubble burst.
To mitigate the inherent risk of investing in a bubble that will inevitably break, carefully consider the reasons for doing so before you do so. If you’re chasing returns out of a sense of FOMO or to jump on a bandwagon, your expectations for returns are likely to be based on speculation rather than an asset’s intrinsic value, which can backfire if and when a bubble bursts.
That’s why most investors should invest in a diversified portfolio of low-cost index funds to reduce the risk of a single investment failing while positioning themselves for long-term growth. It does not have the astronomical peaks of asset bubble investments, but it also does not normally have abysmal lows.