Market bubbles

A market bubble can occur when the price of an investment rises quickly to well above its true value and is followed by a sudden, sharp decline in value. People, often driven by emotion, put so much demand on an investment causing the price to rise significantly to more than its actual worth.

Market bubbles and investor behaviour

Market bubbles have occurred many times throughout history, and continue to happen. There are many factors, including emotion, which influence people’s investing decisions. Bubbles can be difficult to recognize and people often only realize a market bubble existed after it bursts.

One of the earliest recorded examples is the Dutch Tulip Bubble that occurred in Holland during the early 1600s. Speculation over tulip bulb increased to such extremes that, at the peak of the bubble, some tulip bulbs cost more than the price of a luxury home. When the Tulip Bubble burst, prices plunged 99% within a matter of months.

While that much frenzy over tulip bulbs may seem unbelievable, it was likely driven by basic principles of human nature that still play out today.

Behavioral insights show that market bubbles can result from herd behaviour, overconfidence, and confirmation bias. This leads to investors developing a fear of missing out (FOMO). They hear stories of other investors making a lot of money on an investmentInvestment An item of value you buy to get income or to grow in value.+ read full definition, so they throw caution to the wind and eagerly jump into the market.

As prices skyrocket, they get caught up in the excitement of huge potential gains. News articles and social media may confirm to them in their minds that are doing the right thing. But they downplay the fact that inflated prices often don’t represent the true value of the underlying assetAsset Something of value that a company or an individual owns or controls. Examples: buildings, equipment, property, a car, investments, or cash. Can also include patents, trademarks and other forms of intellectual property.+ read full definition, be it a tulip bulb or a stockStock An investment that gives you part ownership or shares in a company. Often provides voting rights in some business decisions.+ read full definition. At a certain point, some investors will begin to sell – either to cash-out their profitsProfits A financial gain for a person or company. Equals the money left over after you subtract your costs from the money you made.+ read full definition or due to a bad news story – which causes other investors to sell and as the selling intensifies, prices collapse and the bubble bursts.

The bigger the bubble, the greater the damage when it bursts.

Three market bubbles of modern times

The speculative bubble of the 1929 Wall Street Crash

During the “Roaring Twenties” in America, people were enjoying the prosperity of an economic boom. The Dow stock indexIndex A benchmark or yardstick that lets you measure the performance of a stock market, part of a stock market or a single investment. Examples: S&P/TSX, S&P/TSX Canadian Bond Index.+ read full definition soared and all types of investors were speculating wildly on the stock marketStock market The collection of markets and exchanges where stocks, bonds and other securities are issued or traded.+ read full definition. When it became apparent that the economic boom was actually an over-inflated speculative bubble, investors started selling in a panic. When the stock market crashed on October 28th and 29th, investors instantly lost fortunes. Some stocks lost over 90% of their value.

The dot-com bubble of the 1990s

The advent of the Internet ushered in a massive wave of speculation in technology-based companies. Hundreds of startup dot-com companies achieved multi-billion dollar valuations as soon as they went public, even though they had barely generated any profits. Investors poured massive amounts of money into high-priced tech stocks in the belief that these firms would be profitable. After the dot-com bubble burst, many of these startups went bankrupt and investors were left with worthless stock.

The US housing bubble of 2007 and 2008

In the mid-2000s, many investors felt that owning real estate was a safer bet than tech stocks. Interest rates were low and banks had reduced their borrowing requirements. Demand exploded for homeownership, as did risky borrowing, mortgageMortgage A loan that you get to pay for a home or other property. Often the loan is for 20 years or more. You make a set number of payments for a set amount each year.+ read full definition fraud, and house flipping. The bubble burst when, among other things, home supply outstripped demand, prices crashed, and masses of homeowners defaulted on mortgages.

Key Point

It is hard to recognize a bubble or predict when it will burst.

Market bubbles are rarely easy to detect, but they do share one common trait — they all eventually burst. Learn more about the risks of investing and how diversification can help reduce your risk of loss from a market bubble.

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