A stock market bubble, also known as an asset bubble or speculative bubble, is when the prices of a stock or asset rise exponentially over a period of time, well above its intrinsic value. eventually, prices hit a wall and then fall very far, very fast, when the bubble “bursts”. bubbles can occur in all kinds of assets besides stocks, from real estate and collectibles to commodities and cryptocurrencies.
how does a stock market bubble occur?
A stock market bubble is driven by pure speculation. A bubble begins to form when there is an increasing acceleration in the price of an asset that far exceeds the intrinsic value of the asset. That means people are willing to pay more and more for a security or other asset, beyond what is expected based on things like demand, earnings, revenue, or growth potential.
Irrational exuberance is a phrase popularized by former Federal Reserve Chairman Alan Greenspan to describe the collective enthusiasm among traders and investors that fuels rapidly rising prices that outperform underlying fundamentals. Whether you call it crowd mentality, herd bias, bandwagon effect, or fomo, there is a self-perpetuating cycle where people want to buy an asset because its price is rising, driving the price even higher. and makes even more people want to buy that.
It is important to note that not all periods of rapid price acceleration are bubbles. For example, after a recession or bear market, it is normal for asset prices to recover considerably. While hope and speculation can also drive such a rally, meaning that the worst of the market downturn or an economic slowdown is over, the key difference is that these price increases can ultimately be justified by fundamentals. /p>
stages of a bubble
Stock market bubbles generally follow the same five stages, first identified by American economist Hyman Minsky:
In the early stage of a bubble, a big change or series of changes affects the way investors think about the markets. this paradigm shift could include a significant event or innovation that causes well-intentioned people to change their expectations of the asset in question.
The crowding out stage results in a price surge, but things really speed up during the second stage of a bubble. the boom phase attracts speculators who help increase the price of the asset as word spreads about their gains.
The fervor intensifies as the asset price soars. During the peak euphoria stage, people are motivated more by emotion than by a rational justification for the huge increase in prices. And because new entrants are eager to buy, there is a feeling that someone will always be willing to pay more for the asset.
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Inevitably, rising prices end up being too good to be true. booms are followed by busts, and some people start selling to lock in profits as the bubble enters the profit-taking stage. the bubble has been burst, and those investors who recognize these signs will reap their profits early.
While some late-game speculators may have previously held out, hoping that an asset’s price will rise again, when the bubble reaches its panic stage, that is no longer sustainable. instead, the fervor to buy an asset has been replaced by a panic to sell. falling prices quickly wipe out profits and encourage more panic selling.
examples of economic bubbles
People often refer to any rapid increase in prices as a possible bubble, but these events are actually less common than you think. famous bubbles include:
- tulipmania. the bubble to which all other bubbles are compared, tulipmania hit holland in the 1630s when the price of dutch tulips rose rapidly, far beyond its value. tulip prices plummeted just a few months later, with the flowers eventually selling for a fraction of their peak prices.
- south sea company. amid the Speculating on the potential profits of a trading monopoly in the 1720s, South Sea Company’s stock price surged within months, only to collapse, resulting in an economic downturn.
- dotcom bubble. the late 1990s saw many internet-centric companies launching initial public offerings (ipos). The then-new, rapidly expanding internet industry was a paradigm shift, with many investors eager to invest, even in stocks of companies that failed to demonstrate sustainable business models, such as pets.com, which it liquidated a few years ago. less than a year. public. Some people even took day trading as a full-time job, and the broader S&P 500 more than doubled in value in a matter of years. but as individual companies collapsed, that led to a broader stock market crash.
- the us. uu. housing bubble. in the mid-2000s, a bubble began to form in the us. uu. housing market amid a very rapid acceleration in house prices. speculators began to change houses, hoping to make a profit, and the average price of a US dollar. Homes increased nearly 80% between 2000 and 2006. But people who couldn’t afford a home were buying and the bubble finally burst. house prices took about 10 years to fully recover.
what causes an asset bubble?
The initial stages of a bubble can be benign. For example, a Wall Street analyst might improve his recommendation on a stock, and that draws the attention of investors, who then become more optimistic. Likewise, rumours, a prominent investor, news reports, or information shared online or on social media could also spark speculative fervor.
what makes an asset bubble burst?
An asset bubble bursts when there is a drastic change in expectations. for example, a prominent market participant could sour enthusiasm. or the bubble could burst as a result of selling activity that makes investors nervous, causing a panic that causes people to sell the asset as quickly as possible and prices to decline further.
While market participants may try to curb both the surge and decline in prices during a bubble, there is little they can do other than urge caution. During big dips or periods of intense volatility, the us The Securities and Exchange Commission (SEC) has a mechanism to prohibit trading activity in individual assets to try to give the market a chance to cool down.
how to recognize a bubble economy
It’s tempting to classify something as a bubble when the price is skyrocketing, but it’s actually hard to classify something as a bubble until it bursts. Not all speculative activity that stimulates price increases in the first place results in a change in expectations that sends the price plummeting.
Still, it is possible to recognize signs of a bubble when the price of an asset rises above and beyond its fundamental value. By identifying behavior that aligns with the early stages of a bubble, it is possible to recognize an economic bubble while it is happening, although it is impossible to know if and when prices will eventually fall.
how to invest during a stock market bubble
Because bubbles are inherently driven by speculative behavior, the associated activity falls more within the realm of day trading than long-term investing. even so, it can be dragged by a bubble without intending to do so. For example, the housing bubble of the mid-2000s affected homeowners of all kinds: people who bought or sold when prices rose, as well as those who stayed in their homes while the bubble continued. /p>
To avoid the inherent risk of participating in a bubble that eventually bursts, it is important to carefully consider your reasons for investing before doing so. if you’re chasing returns for some fomo sentiment or to jump on a bandwagon, then your return expectations are probably more driven by speculation than an asset’s fundamental value, which can come back to bite you if, or when, a bubble bursts . .
That’s why experts recommend that most investors buy a diversified mix of low-cost index funds to minimize the risk of any one investment failing while positioning themselves for long-term growth. It may not have the sky-high highs of asset bubble investing, but it usually doesn’t have the extreme lows, either.