Understanding the definition of a stock market bubble can make you a much smarter investor. In the moment, a stock market bubble might seem appealing. In the long run however, they will damage the nation’s economy. They can also lead to you losing money. Uh Oh! But What Is A Stock Bubble?
A Stock Bubble is an economic bubble that takes place when stock market participants drive stock prices above their actual value. As a result, people tend to recklessly invest and the market inflates. These bubbles inevitability pop. When this occurs, the value of stock goes down dramatically.
There are many reasons for the creation of stock bubbles. They also come with many economic consequences. Scroll down to discuss what is a stock bubble and find out what causes a stock market bubble.
Causes Of A Stock Bubble
The term “bubble” in an economic context generally refers to a situation where the price of something such as an individual stock, financial asset, or even a whole market exceeds its fundamental value by a large margin.
Its value becomes much greater than its actual worth. This leads to people purchasing a large amount of the product or stock. This buying is usually reckless…
But what exactly causes a stock market bubble?
1. Investor Psychology
Stock Bubbles are driven in large part by investor sentiment and psychology, which generates a loop of rising prices and additional buying. Multiple investors buying a product or a stock then pressures other investors to do the same.
The social pressures of the stock market and the appeal of trends leads to increased buying and therefore a rise in the price of the product.
This is known as “Herd Mentality.” This mentality is one of the main causes of Stock Bubbles.
2. New Technology
Another cause of Stock Market Bubbles is the creation of new technology and products. When the newest technological gadget is released, it causes a large amount of excitement and increases the demand for a product. Investors are eager to invest in anything new. This causes the prices for this product to increase, creating a Stock Bubble.
3. Low Interest Rates
Low interest rates can also create Stock Bubbles. Low interest rates encourage people to borrow money that they can then use for spending, expansion, and investment. When interest rates are low, investors are more likely to take risks and spend recklessly.
4. Supply And Demand
Classic supply and demand principles are common causes for stock market bubbles. If there is a shortage of an asset, the cost of that asset will inevitably climb. High product prices are a characteristic of a Stock Bubble.
This can easily be manipulated and is the reason high end clothing lines have been caught burning surplus stock. Keep the supply low and the demand soars!
Stages Of A Stock Bubble
The first stage of a Stock Market Bubble is displacement.
This occurs when investors get enamoured by a new product.
New and innovative products or historically low interest rates are the most common reasons for this displacement.
These things get investors excited and caught up in the excitement of risky investments and the potential to make huge amounts of money.
Then the “Boom” happens.
This phase refers to the abnormal speed at which prices increase. More and more investors enter the market.
During this phase, the asset that caught investors’ interest will typically receive widespread media coverage. This media coverage only increases spending. People become scared to miss out on a once-in-a-lifetime opportunity and the chance to get rich.
The phase is known as “Euphoria” then occurs.
During this phase, caution is thrown to the wind. Investors invest with extreme recklessness.
The “high” that comes from gambling is felt during this phase. Investors tend to spend money that they might not even have. Those who got in early are feeling confident that they will be successful.
If you find yourself feeling elated and super psyched about an investment… check yourself. Could this be the euphoria stage? If so… move on to the next stage now!
4. Profit Taking
“Profit Taking” happens next. This phase is the beginning of the inevitable pop of the bubble. Uh Oh.
During this phase, the “smart money” starts selling positions and taking profits. “Smart money” refers to money that is controlled by institutional investors, central banks, and other financial professionals.
These investors are considered experienced and well-informed. They tend to have advantages over the average investors. Despite their experience, it is hard for anyone to estimate the exact time the bubble will pop.
Panic is the last phase of a Stock Market Bubble.
The bubble will always burst, it is just a question of when. In this last phase, investors decide that the stock prices far exceed their actual value and they begin to sell their shares. This triggers a massive sell-off.
This traps investors who were not able to sell their shares fast enough. Those investors will lose large amounts of money. Sometimes all of it!
Popping A Stock Market Bubble
Stock market and market bubbles can lead to a more general economic bubble.
Stock bubbles can lead to inflation of a regional or national economy. The popping of a Stock Market Bubble is therefore dangerous because it can lead to economic depressions on a large scale.
Examples Of Stock Market Bubbles
The Great Depression
Many historians feel the U.S. experienced this from 1929 to 1933 during the Great Depression Era.
United States citizens are still feeling the effects of this era today!
The Lost Decade
Another example of a Stock Bubble popping was the bursting of equity and real estate bubbles in Japan from 1989 to 1992. During this time, the real estate and stock market prices of Japan’s economy were greatly inflated.
In early 1992, the bubble burst. Land values everywhere fell.
As a result, Japan’s economy stagnated. This led to what is known as the Lost Decade. During the Lost Decade, Japan’s economy saw a significant slowdown.
The Dotcom Bubble
The Dotcom Bubble was a rapid rise in U.S. technology stock equity values. It was fuelled by the large number of investments in Internet-based companies in the late 1990s. The growing use of the internet and excitement for new technology was the main reason for these investments. When the bubble popped many Internet-based businesses failed, but some succeeded.
Amazon was a result of the Dotcom Bubble.
Amazon is a great example of the importance of timing in Stock Bubbles. If you time the popping of the bubble correctly and sell your stocks at the right time, you can be extremely successful.
That is what motivates so many investors to take risks when it comes to Stock Market Bubbles, as there is a slight possibility that they will make money after the bubble pops.
Unfortunately, regular investors tend to suffer the consequences of the bursting of Stock Bubbles. Large investors with insider knowledge are the ones who escape the Stock Bubble before disaster strikes.
Summary: What Is A Stock Bubble?
You may be wondering whether we are in a stock market bubble right now?
That my friend, is a very difficult question.
Individual stocks have soared to all time highs and cryptocurrency has exploded over the past 12-months. Does this mean the bubble is about to pop? Or are we just getting started?
Well… anyone who claims to know the answer is either naïve or… lying.
Timing the market is notoriously difficult (or impossible).
Good luck and may the investing gods be with you.