A financial bubble – which is often referred to by other names, such as an asset bubble or an economic bubble – occurs when the price of something, such as a financial asset, individual stock, or entire market, exceeds its fundamental worth by a large margin.
Throughout the history of financial bubbles, some bubbles stand out. First, there was the Dutch Tulip Mania of 1637, which occurred when speculation drove the price of tulips to extremes. In the year 2000, there was the Dot Com Bubble, caused by the bull market in the US driving up prices of technology and internet stocks, that burst in 2002.
But how do financial bubbles develop? Economist Hyman P. Minsky has identified the five typical stages of a bubble, which we will cover below.
The 5 Stages of a Financial Bubble
In the displacement stage, investors become overly enthusiastic about a new asset or invention. In the case of the Dot Com Bubble, they were excited about Internet-based companies, believing that any business that operated online would be profitable. This caused stock prices to soar.
Like all financial crises, there was the belief that the prices of these Internet companies’ stocks would only continue to go up. When entrepreneurs and other businesses realized what was happening, they began launching Internet companies that investors assumed would be worth millions. However, many of these businesses were overvalued and ended up flopping.
2) A price boom
A price boom occurs when more and more people begin to enter the market. There is often widespread media coverage of the asset in question. Fearful of missing out on a once-in-a-lifetime opportunity, high numbers of traders and investors enter the picture.
During the Dot Com Bubble, more and more money started to flow into Internet companies. Between 1995 and 2000, the NASDAQ index rose from below 1000 to over 5000. This can be accredited to the laws of supply and demand: the demand for these stocks was high and the supply was relatively low, leading to higher prices.
During this phase, asset prices skyrocket and there is a belief that this particular asset is destined for greatness and untouchable – no matter how low prices may go, a market of buyers willing to pay will always be readily available.
Interest in Internet-based companies grew during the Dot Com Bubble, and by 10 March 2000, the NASDAQ index peaked at 5048.62. Investors were spurred on by investment banks that fuelled speculation and encouraged investments. Some people quit their jobs to trade the financial market and a lot of people invested their hard-earned money in hopes of high returns.
At some point, people start questioning if the assets were overpriced. This, combined with other factors, leads people to begin selling off their shares. For example, by 14 April 2000, the NASDAQ composite index had fallen by 25% as people began to sell their shares ahead of Tax Day.
In this phase, many people have started seeing the fall in stock prices and want out. By October of 2002, the Dot Com Bubble stocks had lost most of their value; they had fallen by 76.81% since their peak in March of 2000. Those who managed to get out early may have made a profit, but more than $1.755 trillion was lost.
Some of the biggest losers when it comes to financial bubbles are those who borrow to invest. The greatest lesson to learn from bursting bubbles is to avoid borrowing more than you can afford, diversify your portfolio, and do your research. Unfortunately, it can be difficult to plan ahead as it is commonly agreed upon that bubbles can only be identified in hindsight, so making a variety of wise and diverse investments may serve you better in the long run.