Asset prices fluctuate as the market reacts to information regarding the underlying fundamentals that affect valuation, such as growth, profitability, cash flow, etc. Bubbles occur when asset prices grow beyond what the fundamentals justify.
Asset bubbles have been occurring regularly at least since Ancient Rome, wherever markets existed. The “Tulip Mania” in 17th century Holland is a well-documented example, where the price of tulip bulbs started to increase suddenly in 1634 and then collapsed dramatically in 1637.
Types of Asset Bubbles
Bubbles can form in just about any market for tradable goods. Stock market bubbles occur when the price of a stock, sectoral index, or even the market as a whole, increases beyond its defensible value.
Bubbles can also occur in all asset classes, including real estate, currencies and commodities (e.g. gold, oil). Credit bubbles occur when the amount of lending increases sharply to unsustainable levels, often in a specific type of debt instrument, such as corporate bonds.
Stages of Bubbles
Most participants in asset bubbles become financial casualties. It is therefore important to understand how bubbles form, how they burst, and how to avoid them. Bubbles go through five well-documented stages from initial formation to collapse.
- Displacement: This is when the delusion is first formed in the mind of the early investors. The notions often resemble those that had failed before, but these early investors are convinced that “this time it’s different.” Other investors remain skeptical.
- Boom: The price increase begins to gain momentum, attracting media coverage and the attention of new investors driven by FOMO (fear of missing out).
- Euphoria: The price continues to rise, vindicating the early investors. Doubters start to feel stupid and are eventually persuaded that this time really is By now, the general public is piling in to get their share.
- Profit-taking: Early investors see handsome gains and the wiser ones choose to sell before growth begins to falter. There are plenty of buyers, so the price is unaffected.
- Panic: Growth inevitably slows as demand saturates. Later investors become particularly nervous when returns fail to meet expectations. Then a minor event typically triggers an avalanche of selling activity and the bubble “bursts.” Most investors see their investments evaporate.
The same crowd psychology that drives the price up ultimately brings the price down with equal force. Those who sold before the bubble burst make money. All others lose.
How Asset Bubbles Lead to Recession
Asset bubbles can be large or small, and their effects can be restricted to specific investors or widespread across entire economies.
For example, the tech bubble of 2001 had a severe impact on Silicon Valley and the technology-heavy Nasdaq index, but had little effect on the wider economy. But the effects of the Great Financial Crisis of 2008 spread from the US housing market to the entire globe.
The aftermath of a bubble is far more severe when powered by borrowing, as losses and gains are magnified. Margin trading is a good example. An investor who borrows 50% from a brokerage firm to invest in stocks would get a 20% gain or loss if the market moves 10%. But the investor would lose everything and even end up in debt if the stock market falls 50% or more.
How to Protect Yourself from Asset Bubbles
We have written recently about the Terra Luna fiasco in May this year. Retail investors piled into a protocol they did not understand lured by unsustainable returns (a classic red flag). Then it all collapsed under the weight of unsustainable expectations.
According to Joe Davis, Chief Economist and Global Head of Investment Strategy at Vanguard, a US investment advisor with $7 trillion in assets under management, “There's only one sure way to identify an asset bubble, and that's after the bubble has burst.”
You should avoid asset bubbles before they occur by doing the following.
- Be skeptical. Bubble investments typically spread via word of mouth. Beware of trends that you hear about from friends and family or online.
- Think of the fundamentals. Ask yourself “Where is the money/ growth/ profit coming from?” If you can’t understand it, or if no one can explain it to you, steer clear.
- Diversify your portfolio. Putting all your eggs in one basket is at best a bad strategy, and can lead to financial ruin in the case of asset bubbles.
- Work with a financial advisor. A professional advisor can offer objective advice and spot the warning signs of unsustainable growth.
Investors’ greatest enemy is not the markets, but their own psychology. Bubbles are formed by psychological factors: herd mentality, short-term thinking and cognitive dissonance.
Intelligence alone does not guard against these mental weaknesses. Isaac Newton was among the most intelligent people of his time, but he lost heavily in the South Sea Bubble of 1720, the world’s first financial crash and Ponzi scheme. He famously complained that he “could calculate the motions of the heavenly bodies, but not the madness of the people.”
It is too late to help Isaac Newton, but you can book an introductory appointment with The Family Office using the link below before the next bubble arrives.
 De Gruryter - https://www.degruyter.com/document/doi/10.1515/jah-2015-0006/html?lang=en
 History - https://www.history.com/news/tulip-mania-financial-crash-holland
 NBER - http://conference.nber.org/confer/2015/EASE15/Jorda_Schularick_Taylor.pdf