An economic bubble occurs when the price of an asset, such as a stock, real estate or cryptocurrency, increases rapidly and significantly, exceeding its intrinsic value.
This rise is often fueled by speculation and FOMO (Fear Of Missing Out), rather than real economic factors.
There are therefore many possible causes:
- Market euphoria: a climate of excessive optimism can lead investors to ignore risks and overestimate the value of an asset
- Lack of regulation: a poorly regulated market can more easily encounter speculation and price manipulation
- Asymmetric information: when some investors have access to privileged information that others do not have, this can create imbalances in the market and encourage the formation of "bubbles"
- Low interest rates: when the cost of money is low, investors are more likely to take risks and invest in speculative assets.
The phases of an economic bubble
- Beginning: investors are carried away by a scenario that promises to be a paradigm shift for the economic context. "This time it's different"
- BOOM: the price of the asset begins to attract the attention of most investors, large and small. "When everyone talks about the same tool/asset"
- Euphoria: the bubble reaches the point of maximum expansion, with valuations very distant from the fundamentals, provided that there are underlying fundamentals
- Take profit: some investors realize that the asset prices are based on irrational bases and begin to close their positions
- Panic: the end of the bubble arrives. The first take profits of a few investors spread like wildfire, until they cause the collapse of disproportionately inflated prices. The downturn pushes investors to sell, sooner or later, based on their emotional resistance.
Historical example
There are many, but I will talk about one of the "oldest"
The 17th century tulip bubble in the Netherlands. The bulbs were a status symbol and collector's item. With the release of new varieties and new colours, demand grew dramatically, causing prices to rise sharply. One of the most particular bulbs cost around 1000 Dutch guilders, considering that the average annual income at the time was 150 guilders.
The strong demand that had pushed prices to unsustainable levels ran out in a few years and prices collapsed, causing families in debt to purchase the aforementioned bulbs to go bankrupt.
Other bubbles followed: 1929 the Great Depression, 1980s real estate bubble in Japan, the dotcom and subprime mortgage bubbles.
How to avoid them?
It is extremely difficult to identify an economic bubble because what fuels this phenomenon is human greed and irrationality that are part of being human.
However, some precautions can help:
- Avoid speculation by investing wisely and don't look for quick and easy money
- Understanding the investment: if we don't understand in a few minutes what we are investing in, either its value is not clear or it is better to avoid
- Diversify: this deserves first place when it comes to investment. It is essential to invest in different assets in order to reduce risks
- Don't just consider the returns but also the associated risks
- Separate stories from valuations as emotions do not drive rational investing. Cases of people who became millionaires with $1000 are a rarity.
- Don't get caught up in FOMO, invest only out of conviction and never out of fear of missing opportunities.
Remember that investing is a rational process, not a game of chance. Prudence and diversification are the keys to long-term success
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