What are financial bubbles?

Financial Bubbles Definition

When you start investing in stocks or assets, there is always someone who tells you about bubbles and to be careful when they burst. However, do you understand what exactly people mean when they talk about financial bubbles, or do you just have an idea from what happened in 2008? Whatever your case, this article could help you.

To begin, we will start by saying that a financial bubble is an economic phenomenon generated when the prices of a stock or an asset increase exponentially over a period of time, well above its intrinsic value. Eventually, prices hit a limit and then fall very fast, when the bubble “bursts.” Bubbles can occur in all types of assets besides stocks, from real estate and collectibles to commodities and cryptocurrencies.

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 rebound sharply. The key difference is that these price increases may ultimately be justified by fundamentals, but those of a bubble cannot.

What makes these explode?

A bubble bursts when there is a drastic change in expectations. For example, the bubble could burst as a result of selling activity that makes investors nervous. Consequently, this would generate a panic that triggers the sale of the asset as quickly as possible and the price falls.

While market participants can try to curb both price spikes and falls during a bubble, there is not much they can do other than urge caution. During large dips or periods of intense volatility, the U.S. Securities and Exchange Commission (SEC) has a mechanism to prohibit trading in individual assets to try to give the market a chance to cool down.

Examples of financial bubbles

People often refer to any rapid price increase as a possible bubble, but these events are actually more infrequent than you might think. However, this phenomenon is not new, and it already has a historical background.

Some examples of widely known financial bubbles are as follows:

  • Tulip mania. This could be the easy first bubble that everyone knows when studying this economic phenomenon. It gave rise to the term ‘Dutch syndrome’, as the tulip craze struck Holland in the 1630s when the price of Dutch tulips rose rapidly, far beyond their value. Tulip prices plummeted just a few months later, and the flowers finally sold for a fraction of their peak prices.
  • Bubble “dot com” In the late 1990s, many Internet-centric companies filed for initial public offerings (IPOs). The then new and rapidly expanding Internet industry was a paradigm shift, and many investors were eager to invest. The problem is that it was done even in shares of companies that did not demonstrate sustainable business models. Even the collapse of some individual companies caused a broader collapse of the stock market.

One of them was just over 10 years ago

  • The American housing bubble. In the mid-2000s, a bubble began to form in the U.S. housing market amid a very rapid acceleration in house prices. Speculators began selling houses, hoping to make a profit, and the median price of a house in the United States increased almost 80% between 2000 and 2006. But people who couldn’t afford the houses were buying and the bubble finally burst.  It took about 10 years for house prices to fully recover.

How to recognize an economic bubble properly?

It is tempting to classify something as a bubble when the price shoots up, but it is actually difficult to classify something as a bubble until it bursts. Not all speculative activity that spurs price increases in the first place results in a shift in expectation that causes the price to drop sharply.

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 lines up with the early stages of a bubble, it is possible to recognize an economic bubble while it is occurring, although it is impossible to know if and when prices will eventually fall.