Money & Investing – Banks.com

We’ve heard a lot about bubbles lately, especially the housing bubble and the subprime bubble. These are almost always followed by an historical perspective looking at the tech bubble. But what are these bubbles? And why do they form?

Investment bubble: A definition

Basically, a bubble is an upward movement that takes the price of an investment well above what might be reasonable when the fundamentals are considered. It basically results when everyone wants to buy one particular investment, or class of investments. Because there is so much buying and demand for the investment, the price sky rockets. We saw this in the housing market as prices spiraled out of control when people were able to get easy credit and houses were being bought left and right. An investors were buying up the securitized debt.

Why do investment bubbles form?

Stock Trading To Go wrote a great article on 7 reasons that investment bubbles form. However, I pretty much managed to put the reasons into two categories:

1. Investment fundamentals (to get things going).
2. Human emotional response (to send things spiraling out of control).

Basically, a market or investment class starts moving upward, gaining in value. Fundamentally, this makes sense at first. There is demand for the investment, and there is a reason that people value it. Stock Trading To Go even points out that there may be a correction. A retracement occurs as worry surfaces that the investment might be overbought or that its price is rising too quickly. But if the buyers keep coming and the resistance is overcome, confidence in the investment is seen as “proven”, and the price soon sky rockets, feeding the bubble.

Exaggeration of the value of the investment is part of the human element. “Experts” tout the investment as the next big thing. Sentiment works in favor of the investment. Everyone starts buying in. Additionally, everyone wants in because they want to buy now, before the prices go even higher. “Buy low, sell high” gets replaced by a “buy high, sell higher” mentality. Of course, in a bubble situation only a few actually make money in this way, selling just before the bubble bursts.

As you can see, it can be easy to get caught up in the moment and the frenzy.

Disclaimer: I am not an investment professional. Nothing in this piece or on this Web site should be construed as investment advice. Before making investment decisions, do your own research and/or consult with an investment professional. All investment comes with the risk of loss. You are responsible for your own investment decisions and any loss that may result from your decisions.

image credit: Marcin Deregowski via Wikimedia Commons

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