What is a Bubble and Why do Traders Want In?

Apr 13, 2021

What is a Bubble?

A bubble is an economic cycle where the market value of an asset increases rapidly. Enthusiastic market behaviour drives the swift escalation of an asset’s price.

So, what happens is that an asset is traded within a price range that largely exceeds its intrinsic value. This means that the price it trades at is not in line with the asset’s fundamental value but by a large margin. An equally-as-fast decrease then follows the quick inflation. Naturally, this causes the bubble to ‘burst’ or ‘crash’. Think of it in these simple terms: what goes up must come down.

Bubbles are often attributed to a temporary lapse in disbelief by those participating in trades. It is usually after the bubble has burst that investors realise they were, in fact, contributing to blowing it up.

How Does a Bubble Work?

So, how does a bubble work? There is much debate around this. Some economists do not believe that bubbles even occur. Their thinking centres on the fact that asset prices are not stable and often deviate from their intrinsic value. So, if that’s the case, does a bubble actually form, or are these fluctuations in value normal? However, those who do believe in them will identify and study them once the price drops massively. Change in investor behaviour is linked to the formation of bubbles, but what motivates this change is not always clear.

When defining and explaining economic bubbles, American economist Hyman P. Minsky’s findings are most commonly used. Minsky identified five stages of a typical credit cycle, which help decipher where financial instability comes from. His theories only came into the spotlight during the U.S. mortgage crisis in 2008, when people sought to formulise what happened. Let’s take a look at the five stages.

  1. Displacement

The initial stage is displacement. This occurs when a new paradigm catches the interest of investors. This could be a new technology or product or simply historically low-interest rates.

  1. Boom

Soon after, prices begin to rise and then snowball. Momentum is gained as more investors enter the market. There is a general sense of needing to jump on the bandwagon. And as such, more and more people get involved, buying up the asset.

  1. Euphoria

Once the asset’s price has skyrocketed, euphoria kicks in. At this point, caution is thrown to the wind, and the ‘greater fool’ theory begins to play out.

  1. Profit-Taking

This stage is all about knowing when to tap out. But deciding when the bubble might burst is not easy. Especially if you consider that those deep in the centre are considered to have lost sight of logic. Anyone who can spot the leak in the bubble before it actually bursts though could benefit from the bubble by short-selling their position.

  1. Panic

During this period, the asset’s price changes course and begins to decline as supply has now overtaken demand. Investors are now looking to liquidate the assets they own at any price.

Why Traders Get Involved

Aside from profit-taking, what drives speculators and opportunistic traders often boils down to psychology. The term ‘Behavioural Finance’ suggests that psychological influences and biases affect the behaviour of investors. In turn, this causes anomalies in the stock market. The three behaviours commonly considered are:

  1. Herd mentality

Getting involved because everyone else has.

  1. Short-term thinking

Looking to make money fast, meaning an immediate return on investment.

  1. Cognitive dissonance

Only absorbing information that affirms your approach, even if there is evidence against it.

What Happens When the Bubble Bursts?

Bubbles are typically short-lived and can burst as quickly as they are inflated. Both the damage and gains can vary. Sometimes the aftermath is only felt by a few. But, it can trigger much larger effects at the other end of the spectrum, like a stock market crash or economic recession.

Of course, it all depends on how much money is involved. As well as what makes up the bubble. For example, is it a specific asset class that is relatively small, or is it a major sector like residential real estate? The size will determine just how much damage ensues.

Bubbles in History

Tulip Mania

Ever heard of Tulip Mania? You may be wondering what a flower has to do with economic bubbles, but in the early 1600s, it was the tulip brought down the Dutch economy.

The tulip bulb trade started by accident. A botanist planted bulbs he had sourced from Constantinople so that he could conduct research. These were then stolen and sold, with rich people collecting the rarer varieties. These fetched incredibly high prices, and as such, the bubble began to grow with fortunes being made overnight.

The bubble burst when a large purchase went awry – the buyer didn’t show up. It began to be clear that the price increase wasn’t sustainable, and soon panic spread through Europe. This caused the price of any tulip bulb to decrease dramatically. Even though the Dutch authorities stepped in and relieved contract holders of their obligations for 10% of the contract value, fortunes were still lost.

Dot-Com Bubble

A similar thing happened to the internet in the 90s. Investments in internet and technology-based companies inflated the dot-com bubble. In the 1990s, investors began to pour their money into internet start-ups. As technology evolved and the internet became much more accessible, stocks in these companies started to skyrocket, creating a frenzy.

Shortly after, panic ensued. The stock market saw a 10% loss, and it didn’t take long before companies that once had millions in market capitalization became worthless. At the end of 2001, the majority of the public dot-com companies had gone under.

U.S. Housing Bubble

The U.S. housing bubble was in part the result of the dot-com bubble. The value of real estate began to rise as the markets started to crash. While this was happening, demand for homeownership multiplied, and interest rates began to decline. Banks altered the requirements in place for borrowing and lowered their interest rates. Adjustable-rate mortgages (ARMs) were offered with frequency, so when the stock market began to rise again, the interest rates did, too. This left homeowners with ARMs they were unable to pay since their mortgages were refinanced at higher rates. The value of homes declined and led to a sell-off in mortgage-backed securities. The result was millions of dollars in mortgage defaults.

To Sum Up

Whether you are skeptical about bubbles or not, it is fair to say that these kinds of fluctuations in asset value have the power to wreak havoc on economies. It’s wise to familiarise yourself with the five stages of a bubble’s lifecycle, so that you may be able to identify the next one.