A financial bubble is most commonly defined in very complex, economic vernacular. But what it boils down to is that an economic bubble is the growth of popularity of an asset class that exceeds its actual value. Do you remember the dot.com bubble in the 1990s and the horrific housing bubble we just crawled out of in 2007 and 2008? CryptoCurrencies are thought to be in a bubble as I speak.
A bubble is characterized by frenzied and irrational purchases of assets that are not worth their price fundamentally, but based on emotion, speculation and yep, plain ole’ hype. We buy high thinking we can sell higher because we believe in the wave or trend. The escalation is based on elements that are so fragile that any kind of substantive change could pop it such as: interest rates, sickness, or social views.
Bubbles can also be created by governmental or legislative shifts. Japan’s economic bubble, and to a degree the push for lax lending rules in the US, prompted bubbles of their own due to overheated economic activity, uncontrolled money supply and an expansion of credit.
I think the best way to understand economic bubbles is by reviewing the first recorded bubble back in the 1600’s – adorably called TulipMania. Newly independent Holland was experiencing its Golden Age after breaking free from Spain. At the time tulips were a new and luxurious treat that grew wildly in popularity. So much so that their bulbs began trading for assets with stored value like houses and land. They were so rare and luxurious that a futures market was created for speculation on newly bred varieties. Fortunes were made off the speculative market, and growers and scientists were paid generously for their work in creating new varieties. But like all bubbles, TulipMania popped, some believe due to the plague keeping buyers at home. One day the buyers stopped buying and contracts went unfilled leaving a glut of beautiful tulips with no buyers. Of course, as markets balance the needs of the sellers with the wants of the buyers, this meant the price of tulips tanked and the first acknowledged economic bubble had burst.
Today we might find the mania over tulips hard to understand and irrational, but the traits of TulipMania are just as prevalent in our modern day bubbles. Remember people getting rich off buying stocks of companies that didn’t even do anything in the dot.com age (Pets.com or EToys.com)? Or when we believed we could buy homes valued for half a million dollars on a $40,000 wage. Or the escalation of a currency that purports not to be a currency….you see, we can’t poo poo the irrational exuberance of time we never experienced when in our own time we find ourselves in the same predicament.
So, what have we learned about bubbles and how do we avoid getting caught up in one?
- Frenzied buying or panicked selling is what creates and destroys an economic bubble.
- When speculation is the primary driver for asset price and not the fundamentals of the economic value, the asset could be in a bubble.
- Government forces or changing socio paradigms like in energy that are driving the attractiveness of an asset purchase is a popular shift that can lead to a bubble.
Be calm and realistic in your major economic decisions. Be aware of the actual value of the asset you’re buying and try to make an unemotional evaluation of whether the price reflects the actual value or the value plus a strong (hopefully not irrational) emotional attachment. And stay in your wheel house – don’t jump into trading an asset because it has become popular, know its value before committing your hard earned money.
Ok, this can sound a bit heavy and just because an asset soars in price doesn’t make it a bubble. I just want you to be careful and protect your hard earned dollars. If you have concerns about major economic decisions always feel free to comment or contact us.
We’ll chat again soon –
PS Make sure to share this post on your social if you think a friend might in danger of bubbles!