Asset Bubbles: When to be Aware of Bursting Bubbles

In light of the recent housing market crash, the early 2000’s "dot com" crash, and each of the stock market crashes that followed, we should learn to be cautious of asset bubbles.  These bubbles become dangerous to investors because the larger the asset price increase, the larger the bursting bubble and the larger the losses. What do we need to know to protect ourselves from asset bubbles?

What is an Asset Bubble?

An asset bubble forms when a particular "good" or stock increases in price above any realistic valuation for that particular asset.  Often the increase in price is quick, and after the bubble bursts, the plunge back to the realistic values is also rapid. 

Let's use the recent housing market bubble as an example. House values began increasing in the late 1990’s as demand for housing increased.  The housing demand created inflated prices at an unsustainable speed, and homes quickly became overvalued.   When the housing market crashed in 2007, the bubble burst, and the homes were found to be valued at a lot less than their original appraised amounts.

How Do I Know When an Asset is Developing a Bubble?

As an asset’s value increases at a much higher rate than normal and the demand increases exponentially, we can usually identify an asset bubble.  Even when a stock increases quickly, it will typically level out or decrease at some point.  This is where asset bubbles can be dangerous.  If you purchase a stock with a rapidly increasing value, you are risking that it will decrease at some point.  Unless you are able to predict the burst, you will be stuck with a stock that may not be worth as much as you paid.

A good way to identify a bubble is to be wary when people are buying something on the assumption that the appreciation will work in their favor. For example, during the housing bubble, people were buying the biggest houses they could qualify for -- and sometimes more than one -- simply because they thought they'd be guaranteed appreciation on the asset. This is the kind of thinking that almost always drives asset bubbles.

Why Shouldn’t I Ride an Asset Bubble?

Jumping on the asset bandwagon is always potentially dangerous.  The bubble could burst at any time, and many people become greedy when they enter the bubble playing field.  Even if you buy intending to sell quickly, the huge increases can influence people to ride the bubble too long.

Overall, if an asset is increasing in value at a high speed, it is probably too good to be true and buyer beware. In the long run, it is better to buy stocks or goods increasing at stable rates and save them for a lengthy period than to buy a bubble that may burst at any moment.

For most of us, trying to play with asset bubbles is no more than gambling. We see the opportunity for quick reward, but it comes at high risk. Unless you have compelling information that makes you think you know better than everyone else, playing with asset bubbles is dangerous.

Photo Courtesy of Lin Pernille

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