How economic bubbles affect investments

An economic bubble forms when the value of any asset (stocks, real estate, or commodities) rises far above its actual worth. These inflated prices are usually fuelled by investor speculation, which causes a rapid upward march that ultimately ends in a sharp decline.

When an economic bubble bursts, investors face significant losses. While economic bubbles are unpredictable, recognising one in formation can help investors mitigate risk and navigate turbulent markets.

• Economic bubbles form when asset prices rise above their actual market value.
• Bubbles are unpredictable, but monitoring asset fundamentals can help avoid risk.
• Diversifying portfolios and setting profit targets can protect you against bubble bursts.
• Understanding past bubbles can help in better decision-making during upswings.

Economic bubbles are caused by many factors, none of which are universally agreed upon by economists. However, a common scenario is a booming economy in which more and more consumers gain confidence and start investing in it.

This results in higher demand for assets, pushing their prices up. As interest rates fall and loans become more accessible, borrowing for investment becomes easier, which increases the demand for these inflated assets even more.

Another factor is the inflow of liquid assets into the economy. When loans are cheap and money is abundant, investors pour capital into assets, driving their prices up even further. However, as the price rises beyond the intrinsic value of these assets, it becomes unsustainable, laying the groundwork for a bubble.

Economic bubbles typically unfold in five stages. Understanding these phases can help you spot potential bubbles before they burst:

1. Displacement: Investors are drawn to a new trend or opportunity, such as a breakthrough technology or a drop in interest rates that fuels demand for loans.
2. Boom: As the trend gains momentum, more investors jump in, leading to a sharp rise in asset prices. Excitement and speculation grow, with some investors ignoring risk altogether.
3. Euphoria: Asset prices touch new highs, far exceeding their actual value. Despite clear signs of overvaluation, people keep buying, convinced that prices will rise still higher.
4. Profit-taking: Cautious investors sense a peak and start selling their holdings to seal in profits. At this stage, the market begins to cool off.
5. Panic: This is when the bubble bursts and asset prices collapse. Panic selling ensues as investors scramble to offload their assets, often at a loss.

The burst of an economic bubble causes widespread instability.

Economic bubbles form in different asset classes. Some of the most common types that have happened in the past are:

• Stock market bubble: Occurs when stock prices rise rapidly, often due to speculation, far exceeding the companies' true market values. An example is the dot-com bubble of the 90s.
• Credit bubble: This type of bubble involves excessive borrowing, typically fuelled by low interest rates. People and businesses take on unsustainable levels of debt.
• Commodity bubble: Commodity prices, such as oil or gold, can experience dramatic increases due to speculation. These bubbles form when demand outpaces supply.
• Market bubble: A market bubble can occur in any sector, including real estate. The US housing bubble of 2007-2008 is a good example, where excessive borrowing and speculation in property markets led to a major crash.

Throughout history, economic bubbles have left a lasting impact on economies and financial markets. Learning from these events enables economists to gain valuable insights into how bubbles form and collapse.

Tulipmania

In the 17th century, the Netherlands saw one of the earliest recorded economic bubbles named Tulipmania. At its peak, one tulip bulb was worth more than a house! But when prices abruptly collapsed, many investors were left bankrupt. This was a prime lesson in the dangers of speculative investments.

The dot-com bubble

In the 1990s, there was a rise in internet-based companies, triggering a wave of investment in technology stocks. This excitement around the ‘new economy’ led to inflated valuations of companies that had little to no profits. As investors became suspicious of the unsustainable growth, the bubble burst in 2000, wiping out trillions of dollars in market value. Many tech companies went bankrupt as a result.

The US housing bubble

From 2000 to 2007, the US housing market saw rapid price growth. This was driven by low interest rates and lax lending. Many borrowers, even those with poor credit, took out mortgages they could not afford. When interest rates rose, borrowers defaulted. This led to a chain reaction that caused the collapse of major banks and resulted in a global economic crisis.

When an economic bubble bursts, the impact on investments can be severe. Investors who buy into the bubble during its peak will face significant losses. However, not all is doom and gloom; savvy investors can still navigate bubbles and even profit from them.

Here are some things that you should do to avoid getting caught.

Monitor asset fundamentals

Keep tracking the fundamental value of assets you invest in. If prices rise rapidly without any corresponding increase in underlying value, it could be a sign of a bubble. Financial ratios, such as P/E and P/B can help determine if an asset is overvalued.

Set profit targets

One way to protect your investments during a bubble is to set profit targets. Once an asset reaches a predetermined level of return, sell it to lock in profits. Timely exit can help you avoid losses when the bubble bursts.

Diversify your portfolio

Diversification is an important strategy to protect against bubble-related risks. By spreading your investments across different asset classes, you lower your exposure to a single market crash. This can help you preserve your wealth even during a bubble.

Economic bubbles are an inevitable part of financial markets. While they can lead to massive losses, being aware of early signs and implementing smart strategies can help you minimise risk.

By understanding how bubbles form and monitoring market fundamentals closely, you can safeguard your investments against such market collapses.

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