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What Is A Bubble?

In economics, a bubble occurs when an asset rapidly increases in value and begins to exceed the “intrinsic” value of said asset. The inflation of this bubble is followed by an equally rapid decline in prices, sometimes referred to as a “crash.” Often bubbles are only identifiable in retrospect, although they are characterized by the presence of warning signs that, while not apparent in the moment, become obvious after the fact. Bubbles have a lot to do with investor psychology, and are fundamentally caused by human behavior. Essentially, as prices on an assets rise to previously incredible levels, investors begin to experience a euphoric desire to profit that causes them to throw caution out the window. Bubbles can affect entire industries and indeed entire economies, having extremely harmful ramifications from which it can be difficult to recover.

Tulip Mania

Though this may sound like a thoroughly modern phenomenon, bubbles have occurred throughout history and we have many examples spanning the centuries. In the early 17th century, tulips became a status symbol among the elite merchants of the Netherlands, with rare varieties commanding astronomical prices. The creation of a futures exchange, where tulips were bought and sold through contracts with no actual delivery, fueled the speculative pricing. However, once big orders were unable to be filled, it became clear that the high prices were unsustainable and there was an immediate and harsh crash. Many people quite literally lost fortunes overnight, and the Dutch government had to step in and stabilize the situation by guaranteeing 10% of previous contract values.

Dotcom Bubble

Much more recently, the Dotcom Bubble was an infamous period of time in the 1990s. This occurred as investors poured money into basically any company that had to do with the internet, causing equity markets to swell at an unprecedented pace. This in turn fueled an unrealistic level of growth in the stock market and caused many companies that were not financially ready to rush into IPOs in order to take advantage of the free-flowing capital. Then, these companies became very overvalued as shareholders pushed the stock prices higher and higher. However, as the unsustainable pattern became clear, prices crashed and investors panicked, causing a major sell-off that saw the stock market lose over 10% of its overall value. By the early 2000s, most of the major companies of the dotcom boom had already gone out of business.