As investors, we must always be knowledgeable and keep up with field trends. That’s why understanding the stock market bubble can also help us be more competent in our actions.
At Buffett Online School, we also believe in investing in great companies you understand, and utilizing Free Investing Resources to help you start your financial freedom and investment journey is one of the best ways to learn.
In this article, we will discuss the stock market bubble’s definition, types, and different stages so you can be more aware of this situation in your investing journey. Chloe Lin also shared a quick TikTok video about the stages of the market bubble that you can check to understand this topic quickly.
What is a Stock Market Bubble
A stock market bubble is a situation where stock prices rapidly increase followed by a sharp decline, but the essential parts of the companies, like revenue, profits, and plans, stay mostly the same.
Typically, prices surge quickly and substantially, surpassing their previous values in a short timeframe. Conversely, the drop is swift when they decline and often goes below the initial starting prices.
These bubbles can impact the entire stock market or a particular sector, like specific industries or geographic areas. They usually occur when investors overestimate the worth of stocks, either by miscalculating the actual value of the companies behind them or by trading based on factors unrelated to their intrinsic value.
What Causes Stock Market Bubble
A stock market bubble leads to people purchasing many products, which is usually reckless. Here are some of the causes of a stock market bubble:
1. Investor Sentiment and Herd Behavior
Investor sentiment and psychology cause stock bubbles
Investor sentiment creates a feedback loop of rising prices and increased buying.
When multiple investors buy a particular product or stock, it pressures others to do the same.
Social pressures and trend-following behaviors in the stock market contribute to heightened buying activity.
This phenomenon is known as "Herd Mentality" and is a significant factor in the formation of Stock Bubbles.
2. Emergence of Innovative Technology
New technologies and products can trigger Stock Market Bubbles.
The release of cutting-edge gadgets generates excitement and increases
demand. Investors are eager to invest in innovations, leading to price surges for related products.
The excitement surrounding innovation contributes to the creation of Stock Bubbles.
3. Impact of Low-Interest Rates
Low-interest rates can encourage borrowing for spending, expansion, and investment.
Investors are more inclined to take risks and spend recklessly when interest rates are low.
Low-interest rates create an environment conducive to the formation of Stock Bubbles.
4. Supply and Demand Dynamics
Classic supply and demand principles are common causes of stock market bubbles.
The scarcity of an asset in the market inevitably leads to higher prices.
Elevated product prices are a characteristic feature of Stock Bubbles.
As high-end clothing lines show, supply manipulation can increase demand and inflate prices.
Types of Bubble
1. Asset Market Bubble: When prices of things like real estate, not stocks, go up very
quickly, it's called an asset market bubble. For example, when the value of things like cryptocurrencies or US homes jumped significantly in a short time.
2. Commodity Bubble: If stuff like gold or natural gas gets expensive fast, it's called a commodity bubble.
3. Stock Market Bubble: It happens when stock prices rise super quickly. Stock market bubbles include stocks—pieces of ownership in companies that quickly become more expensive, sometimes much more than what the companies are worth based on their earnings, assets, and such.
4. Credit Bubble: It is related to a sudden increase in loans taken by consumers or businesses, along with debts like bonds and credit. These assets include company bonds, government bonds, student loans, etc.
Five Stages of Stock Market Bubble
1. Displacement
Displacement is the initial phase of a Stock Market Bubble. It happens when investors become captivated by a new product or historically low-interest rates, which typically triggers this stage.
These factors spark excitement among investors and draw them into the allure of risky investments, driven by the potential for substantial profits.
A stock market bubble happens when established investor beliefs or concepts are displaced by new ideas or a shift in the prevailing paradigm. Displacement could involve introducing new concepts that raise expectations regarding stock performance.
2. Boom
The boom phase pertains to the unusually rapid pace of price increase, accompanied by a growing influx of investors.
In this stage, the asset that has captured investors' attention usually gains extensive media attention. This media exposure further fuels investment activity as individuals become anxious about missing a unique opportunity to become wealthy.
3. Euphoria
In this stage, investors disregard caution because they act with extreme recklessness. In this phase, investors experience a sense of thrill, similar to the excitement of gambling. They may even invest money they don't possess.
Those who entered the market early are confident in their success. If you notice yourself feeling excessively enthusiastic and exhilarated about an investment, you must be cautious and ask yourself if it could be the euphoria stage.
4. Profit-taking
Next comes the phase known as "Profit Taking," which marks the start of the unavoidable burst of the bubble. In this stage, the "smart money" begins to sell their holdings and cash in on their gains. "Smart money" refers to funds managed by institutional investors, central banks, and other seasoned financial experts.
These investors are seen as knowledgeable and well-informed, often holding an edge over the typical investor. However, even with their expertise, it remains challenging for anyone to predict the precise moment when the bubble will burst accurately.
5. Panic
In this phase, investors recognize that stock prices have surged far beyond their actual worth, prompting them to offload their holdings. Panic initiates a substantial wave of selling.
Unfortunately, this situation scares investors who can't sell their shares quickly enough, leading to significant losses and, sometimes, total loss of their investments.
Knowing about the stock market bubble stages may help investors protect or preserve their portfolios. No perfect strategies or methods exist, as these events may happen at certain periods.
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