Economic Bubble & Its Impact On Investment

5 mins read

In this era of economic jargon, it sometimes becomes difficult to catch up on how the economy is progressing. Trends now are dynamic and can vary continuously due to geographical, political, financial and socio-economic factors. These changes lead to the formation of the economic bubble.

What is an economic bubble?

An economic bubble is the part of the economic cycle characterized by a sudden increase in the price of assets such as stocks, housing, or gold, followed by a contradiction in the affected sector. They are driven by speculative trends and not by underlying demands. Investors purchase these assets to sell them at a higher price later. This idea is based on the ‘greater fool theory’, and when the growth slows down, and the new investors are not ready to buy these assets at hyper-inflated prices, this bubble deflates. Usually, the economic bubbles are hard to spot, and they are often identified after they burst.

Causes of an economic bubble

Usually, there is no singular reason for the formation of the economic bubble, and analysts and economists have different views on this matter. Some of the everyday situations that lead to the formation of the economic bubble are:

  • When the economy expands, the number of liquid assets increases. When the lending rates fall, investors borrow money to invest in all these assets. Because of this, the price of these assets starts increasing steeply.
  • When the economy is in the boom phase and the companies and industries prosper and grow, resulting in the higher salary of the employees. It increases the disposable income of the household, in turn increasing the disposable income of the household. Also, people start investing in various assets, leading to an increase in the price of the assets. This leads to the formation of the bubble.

Some of the typical human behaviour that aggravates the situation is:

Cognitive Dissonance:

It happens when people try to avert their woes by finding an alternative that gives them hope.

Herding:

As a standard human behaviour, an investor believes that the majority can’t be wrong.

Short-termism:

This situation arises when people are more concerned about short term gains.

Stages of an Economic Bubble

Any typical economic bubble has five stages:

Displacement:

It occurs when the investor starts focusing on a new technology or trend in the market. This leads to the formation of the bubble. For example, if the lending rates on home loans decrease, many consumers start taking home loans. Because of this, the investors start investing more in real estate. This increases the rate of the property.

Boom:

As the number of investors attracted to this trend increases with time, it is gaining momentum. As a result, prices are increasing at a rapid rate.

Euphoria:

Prices of different assets skyrocket. This doesn’t dissuade the investors. They keep paying higher rates for higher returns.

Profit-taking:

Here, the cautious investors who are conscious of a possible ‘bubble burst’ start selling their assets to make a profit.

Panic:

Because of the above step, the bubble finally bursts, and the price now starts falling rapidly.

Types of Economic Bubble:

In the financial market, there are a large number of asset bubbles. In general, they are classified into four categories:

Credit Bubble:

This kind of bubble involves an increased demand for consumer loans, debt instruments like debentures, bonds, and other forms of credit. If the lending rate decreases or the debt instruments offer higher interest rates, this may rise to a credit bubble.

Stock market bubble:

When the market price of the equity stocks increases at a high rate beyond their intrinsic value, then a stock market bubble is formed.

Market Bubble:

This category of bubble involves other sections of the economy. E.g., if the bubble tends to form in the real estate industry, it will be known as a market bubble.

Commodity Bubble:

This bubble is formed when the price of the commodities such as gold, oil and other metals increase significantly.

Are all economic bubbles bad?

Yes, these economic bubbles are wrong. They can lead to a deep scar on the economy that might take decades to heal but at times can also have some positive manifestations on the micro-economic factors. Economic bubbles have happened before and are likely to happen again. The point is to not worry about ‘when it will happen but ‘how’ it needs to be monitored. Investors need to learn how to safeguard their assets and the purchasing power to build up sufficient reserves to help meet the crisis.

Examples of the economic bubble

One of the known examples is the Dot-com bubble in the United States. In the late 1990s, usage of the internet increased. Hence, many investors started investing in internet-based companies. This impacted the company’s share price that then grew exponentially. As the market peaked, investors got wary, and they started selling assets to make a profit. Because of this, the value of the shares started decreasing. This caused the bubble to burst that impacted the stock market. As a result, many companies went bankrupt or were shut down.

Conclusion

In layman language, the meaning of an economic bubble is when the price of an asset gets artificially and rapidly inflated past the fundamental values due to the demands of the investors. No one can identify the bubbles in real-time. As an investor, you need to be cautious when investing in an upward trend. When the prices are rising, you need to check the assets’ fundamental values before you invest in them.

If the asset’s cost exceeds the intrinsic value or worth, it is a sign of bubble formation. One can invest in such assets to get maximum returns. One should always invest according to his risk appetite. There are plenty of people who made a substantial profit during an economic bubble. Thoroughly analyze the market situation and invest accordingly.