Prices rise slowly at first, following a displacement, but then gain momentum as more and more participants enter the market, setting the stage for the boom phase. During this phase, the asset in question attracts widespread media coverage. Fear of missing out on what could be a once-in-a-lifetime opportunity spurs more speculation, drawing an increasing number of investors and traders into the fold.
During this phase, caution is thrown to the wind, as asset prices skyrocket. Valuations reach extreme levels during this phase as new valuation measures and metrics are touted to justify the relentless rise, and the "greater fool" theory —the idea that no matter how prices go, there will always be a market of buyers willing to pay more—plays out everywhere.
In this phase, the smart money —heeding the warning signs that the bubble is about at its bursting point—starts selling positions and taking profits. But estimating the exact time when a bubble is due to collapse can be a difficult exercise because, as economist John Maynard Keynes put it, "the markets can stay irrational longer than you can stay solvent.
In Aug. In retrospect, Paribas had the right idea, and this relatively minor event was indeed a warning sign of the turbulent times to come. It only takes a relatively minor event to prick a bubble, but once it is pricked, the bubble cannot inflate again.
In the panic stage, asset prices reverse course and descend as rapidly as they had ascended. Investors and speculators, faced with margin calls and plunging values of their holdings, now want to liquidate at any price. As supply overwhelms demand, asset prices slide sharply.
One of the most vivid examples of global panic in financial markets occurred in Oct. Tulipmania describes the first major financial bubble, which took place in 17 th -century Holland: Prices for tulips soared beyond reason, then fell as fast as the flower's petals.
The Internet bubble around the turn of the 21 st century was an especially dramatic one. Numerous Internet-related companies made their public debut in spectacular fashion in the late s before disappearing into oblivion by The story of eToys illustrates how the stages of a stock bubble typically play out.
Investors were very enthusiastic about the stock's prospects, with the general thinking being that most toy buyers would buy toys online rather than at retail stores such as Toys "R" Us. This was the displacement phase of the bubble. As the 8. This marked the boom and euphoria stages of the bubble. Trading volume was exceptionally heavy that day, at nine times the three-month daily average. Although the investors were saying that such expenditures were characteristic in the new economy , such a business model simply is not sustainable.
It added , new customers during the quarter, but the company was not able to show bottom-line profits. Towards the end of the year, with losses continuing to mount, eToys would not meet its fiscal third-quarter sales forecast and had just four months of cash left.
Asset bubbles can begin in any number of ways, and often for sound reasons. Major incubators of bubbles, which often interact or occur in tandem, include:. So far, so good: These are all solid factors for appreciation. However, a problem arises when an asset bubble begins, snowball-like, to feed on itself —and to swell out of proportion to the fundamentals, or intrinsic worth, of the assets involved. Opportunistic investors and speculators are plunging in and pushing prices up even more.
Why are they doing this? It has to do not with fundamentals but with human foibles—psychological and often irrational thinking and actions about money, known as behavioral financia l biases.
These behaviors include things like:. He defined a bubble "as a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases, and bringing in a larger and larger class of investors who, despite doubts about the real value of an investment, are drawn to it partly by envy of others' successes and partly through a gamblers' excitement.
A range of things can happen when an asset bubble finally bursts, as it always does, eventually. At other times, it can trigger a stock market crash, and a general economic recession, or even depression. Much depends on how big the bubble is—whether it involves a relatively small or specialized asset class, vs.
And, of course, how much investment money is involved. Another factor: to what degree debt is involved in inflating the bubble. A major research study, " Leveraged Bubbles ," examined asset bubbles in 17 countries, dating back to the s. It categorized them into four types, but along two basic lines, based on credit—that is, how funded investments were by financing and borrowing.
The study found that the more credit involved, the more damaging the bubble's pop. Debt-fueled equity bubbles led to longer-lived recessions. Even worse were leveraged housing bubbles, like the one that popped in , leading to the subprime mortgage crisis that kicked off the Great Recession. Two decades after investors rushed into Pets. Once again, everyone and their pet hamster wants in on initial-public offerings, no matter what the price or nature of the company. Indeed, the recent craze for Special Acquisition Companies, or SPACs, has seen investors buying newly launched enterprises before the people who launched them have even decided what the enterprise is going to do.
So how does an investor bubble-proof their portfolio? Here are some tips from Ms Benz and other strategists. A period of outperformance only increases the risk of an investment going forward, she pointed out.
Most strategists agree that the electric-vehicle industry is going to be the center of a new economic era. But the same was true of the Dotcom companies. Many of them couldn't turn a profit while waiting for the Internet era to take shape. In fact, according to economist Robert Shiller, citing a "new era" to justify frothy valuations is one of the most dangerous bubble signs of all. Di Mattia to keep a straight face when he describes the case of QuantumScape.
Speculators can help producers hedge price risk, by narrowing the bid-ask gap, providing liquidity to investors on the stock market. A speculation through short selling can also help investors prevent asset price bubbles from forming on the stock market.
For example if a speculator thinks the stock of a company is overpriced, they will sell it short. They wait for the price to drop in order to make a net profit by selling the stock for more than what they bought it for.
Speculation is essential throughout the commodity market since this helps investors manage price fluctuations. In the commodity market, speculation can be used to provide investors and traders with leverage on the stock market when they engage in transactions. Speculators add a significant amount of liquidity to commodity markets, which makes trading easier for all investors.
The forex market is an international platform where national currencies trade. Forex is used by investors to hedge against international currencies and fluctuations in different interest rates. You are also able to diversify your portfolio by investing in different foreign markets. A speculator is someone who buys stocks, goods, and various financial instruments, with the intention of selling them for a profit once the share prices are higher than what they initially paid.
There are various types of spectators on the stock market that all react differently to trends in different stocks. Bullish investors are those who are optimistic about the outlook of the stock market and are confident that they will see strong results. They will buy shares with the intention of eventually selling them for a higher profit.
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