Anatomy Of A Bubble

While the term "asset bubble" has been defined in many different ways, these definitions share some common themes. In a nutshell, an asset enters a bubble when its prices become too high to justify using existing fundamentals, or price determinants. Basically, the asset's price has become too inflated.

Eventually, these high prices become unsustainable, and investors start to sell, fueling a crash in prices. When this happens, investors can suffer serious downside, adversely impacting their sentiment and discouraging them from purchasing the asset until their confidence returns.

By being able to tell the signs of a bubble, investors can potentially manage risk more effectively by helping the risk of buying when asset values are too lofty. Knowing the different phases of a bubble is also helpful, as it can give an investor a better sense of where an asset is in its current cycle.

Step 1: Inception

Every asset bubble needs to begin somewhere, and there is usually some good reason why the assets in question experience notable price increases. While their values may eventually become unjustifiable, there is a reason why these assets generate demand.

The dot com bubble, for example, formed when investors became overly optimistic about technology companies and inflated their values. The strong demand for startups in this space was not without justification.^[1] As the number of people using the internet climbed higher, it is perfectly understandable why the amount of goods and services sold there would rise.

Another good example of a bubble is the real estate bubble that existed in the United States during the 2000s. After the stock market crashed in 2000, many investors were reluctant to put their money into this particular asset class, instead opting to purchase real estate instead.

In some ways this makes perfect sense. While you can live in a house, you can't live in stock, no matter how many shares you buy. Favouring real estate provided strong returns for some investors, and the values eventually became unsustainable, which triggered a real estate crash and in turn the U.S. financial crisis.

Step 2: Gaining Momentum

An asset's price may rise slowly in the beginning, but as more investors enter the market, the asset's price could start climbing more quickly. This price rise may accelerate due to growing media coverage. Journalists and other professionals may take an interest in the security, providing it with greater exposure through different forms of media.

Investors may then succumb to fear of missing out (FOMO), which could increase the number of market participants purchasing an asset and push its price above the point justifiable by its fundamentals. If the price of an asset keeps pushing higher, the sharp gains may attract newcomers. If novices start getting interested in a security, it could be a sign of a bubble.^[2]

Step 3: Euphoria

Asset bubbles eventually reach the euphoria phase, where greed overcomes caution for many investors and other market players. A perfect example of this shift is market observers finding reasons why assets are not in a bubble and are instead justified by current fundamentals.^[2]

The robust optimism that characterises this phase can come in many forms. During the U.S. real estate bubble of the 2000s, for example, this phase became evident when lenders began making increasingly risky loans to borrowers.

Step 4: Profit Taking

When asset values start to look inflated, prudent investors begin taking profits. Pretty much everyone knows the saying "buy low, sell high," but it can be notoriously difficult to time. Warren Buffett, the Oracle of Omaha and one of the world's richest people, has repeatedly emphasized the difficulty of timing the market.^[5]

Step 5: Panic

The next phase of a bubble is the panic phase. During this phase, the sentiment that drove asset prices higher changes direction, resulting in fretting investors and plunging asset values.

The developments that can cause this shift in investor sentiment—and therefore market direction—can vary, notes Charles Kindleberger, an economist who wrote about market bubbles and crashes. "The specific signal that precipitates the crisis may be a failure of a bank, or a firm stretched too tight, or the revelation of a swindle," he said.^[5]

However, once this crisis takes hold, panic selling ensues and asset prices are driven lower.

Step 6: Revulsion

At this point, asset values have fallen so much that investors are very reluctant to get involved.^[5] A perfect example of this is the way the stock market behaved following the financial crisis. After this unfortunate event, many investors—who in some cases saw their 401(k)s and life savings lose close to half their value—didn't want to go anywhere near stocks.

Some investors may view these stages of revulsion as a good time to buy, particularly if the value of different assets has plunged notably.

Summary

While experts have pointed out that markets can be notoriously difficult to time, knowing the phases of a bubble can prove very helpful to investors. By being aware of these key components, investors can make better-informed decisions and increase their chances of meeting their goals.