What Makes an Asset Bubble

by Investing School on September 17, 2010

In investing terms, a “bubble” refers to an economic cycle during which there is a period of very fast expansion, which is then followed by a subsequent contraction. A related definition of “bubble” describes a boost in equity prices in a certain sector of the markets, often due to excessive hype rather than to substance, which is then followed by a dramatic fall in prices when the “honeymoon” wears off and an enormous sell off happens.

“Bubble” is also part of a theory that postulates that security prices will increase to a level higher than their true value… and that the prices will continue to increase until such a time that prices drop precipitously, which is when the “bubble” bursts.

The formation of bubbles can be seen in entire economies, in securities, in stock markets and in business sectors. Changes in the accepted rules of business can be causative, and the changes may be in actual behaviors or in business paradigms. During booms people will be comfortable buying stocks at high prices in the mistaken belief that they can always sell them later at a higher price.

Bubbles that occur in economies and equities markets are responsible for the movement of resources as they are transferred to the market areas of the most intense growth. However, once the bubble reaches its end and bursts, these resources will simply be moved elsewhere again, and prices will fall. Because of this reality, a long-term return on these assets cannot reasonably be expected.

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