What Causes a Bubble?

Most of us would have heard the phrase, “In this world nothing can be said to be certain, except death and taxes”.

Well, you might want to add economic bubbles to that equation. History has shown us that bubbles are bound to happen and, in fact, happen on a fairly consistent basis. It can happen in any asset class, be it stocks, real estate, cryptocurrency or even tulips. However, why do bubbles occur and how do we prevent getting burnt from them?

Over-valued assets

Bubbles occur when the price of a particular asset rises above its true intrinsic value. There are many instances of this happening. The most recent one was during the 2008 great financial crisis.

The price boom of Internet stocks in 1999 was another prime example. Investors had predicted that the Internet was the going to transform the way the world works. However, they invested too much, too fast, leading to prices of these stocks becoming way overvalued and unsustainable. Eventually, the market collapsed, and the price came tumbling down.

Speculation and over-confidence

Greed and impatience is a large contributor to over-priced assets. Investors who have a fear of missing out end up buying assets that are over-priced because of the hope that someone else will buy it from them at an even higher price. This is what happened during the tulip bubble of 1637 when people were speculating on the prices of tulips.

Everyone wanted a piece of the action and fuelled the increase of tulip prices way beyond what was considered acceptable. Eventually, the system collapsed, and many investors inevitably lost money.

Government interventions

Most of the time, governments intervene to prevent market bubbles from happening. For instance, the Singapore government, realising that the price of real estate was getting out of hand, put property-cooling measures in place to prevent a sudden collapse in the future and to stabilise the prices.

However, there are also numerous instances when government interventions unwittingly caused a bubble to form. The housing bubble in 2008 was a prime example. Before the bubble, the US Congress passed a law that Fannie Mae would guarantee mortgages. They wanted to drive demand for properties and to create more jobs.

Unfortunately, it also had the unwanted consequence of creating a system of lending to people who could not pay back their mortgages. The system inevitably collapsed, leading to one of the biggest financial crises ever.

The Foolish bottom line

Bubbles are bound to occur. This can be due to the greed of investors, poor government decisions or speculation of asset prices. Investors need to be alert to any signs of a bubble and ensure that strong fundamental reasons back their reason for investing in an asset. This can prevent us from being burnt in a bubble that can be damaging and difficult to recover from.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.