In finance, a bubble occurs when the price of an asset skyrockets, often due to investor excitement. That hype can mean people pay more for an asset than may be justified. When prices reach a level that's far higher than the asset's valuation, they reverse — popping the bubble.
Bubbles can occur in specific stocks, industries, or even entire markets. There have been two well-documented bubbles in the past 20 years: the so-called dot-com bubble of the late 1990s and the U.S. housing bubble in the mid-2000s.
More recently, pros have compared Bitcoin to past bubbles. Another bubble contender: marijuana, as an entire industry has cropped up following the drug's legalization in many states.
Here's what you need to know about why bubbles form — and why they eventually pop.
It can be difficult to distinguish between an emerging trend that will be long-lasting and a short-lived bubble. Two hallmarks of a bubble: a rapid increase in price, and the speculation among a lot of investors that the price will continue to soar higher.
In investing, sometimes people are eager to buy an asset simply because everyone else is doing so. This is known as herding bias, and is an example of a cognitive bias, or something people do unconsciously that results in poor decisions. With a bubble, herding bias comes into play as investors jump on the bandwagon of a popular asset, rather than doing the necessary analysis to determine whether it fits their investment criteria.
Bubbles pop when the asset's price becomes so inflated that its related valuation — or the underlying company's worth — can no longer be justified. That's because investors often are making speculative bets, and the demand they're banking on hasn't yet materialized.
As the bubble pops, just as there was an initial rush to buy that asset there can be a panic to sell — causing the price to plummet quickly.
Check out the video below, which illustrates how bubbles form.
Many Internet-focused companies filed for initial public offerings in the late 1990s and early 2000s, and investor excitement for this burgeoning industry helped fuel a broader rally in the stock market. From early 1997 to mid-2000, the S&P 500 more than doubled in value.
But many of the new publicly traded companies of that era didn't have sustainable business models. One oft-cited example is Pets.com, which liquidated less than one year after going public. Even Amazon was caught up in this crash; by 2002, the company had lost 90% of its value.
More recently, the U.S. housing bubble in the mid-2000s saw a similar rapid escalation in home prices, followed by a swift crash. The average price of a U.S. home doubled between 2000 and 2006, before plummeting more than 30% by 2009, according to data from S&P Dow Jones Indices. Housing prices didn't recover nationally until 2016.
In theory, a savvy investor could make money during a bubble by buying early and selling before the bubble pops. Unfortunately, that type of timing is difficult to master, even for professionals.
While bubbles can be fascinating to watch from afar, it's not fun when one bursts in your portfolio.
Instead of trying to pick the latest, hottest winner in the stock market, experts recommend a more proven approach: investing in the market itself. Index funds track the performance of a particular market index, like the S&P 500, which has steadier long-term returns of about 10% annually.
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