Five Things Investors Must Always Remember about Bubbles

It appears that we are living in the age of bubbles; U.S. stock markets, cryptocurrencies (especially bitcoin) and real estate almost everywhere are bubbling like crazy. To make matters worse no less a personage than Allen Greenspan is sending out warnings about a bond bubble.

This means it is a good idea for every investor, speculator and person with a bank account to take a fast refresher course in bubbles. There are a few things everybody should know about bubbles and keep in mind when he or she makes financial decisions.

What you need to know about Bubbles

Here are five very important pieces of information about asset and other bubbles that every investors needs to be aware of:

  1. A bubble is a pattern of behavior that is totally separate from the asset or security involved. That means whatever is bubbling can be perfectly sound and a legitimate investment it is simply far overpriced. In many cases something real gets blown out all of proportion by hype and unrealistic expectations. A class example of this was the .com bubble of the late 90s. The tech was very real and the potential was great but the expectations lost touch with reality. It took Amazon 20 years to achieve its’ potential. A similar thing is happening with cryptocurrencies today it will take a decade or longer for that technology to become widely used and hit its full potential.

  1. A bubble can last a lot longer than most people expect. The Australian Real Estate Bubble started back in 2000 and shows no signs of ending. The Cotton Bubble in 19th Century America dragged on for 60 years; from roughly 1800 to 1860, ending only with the outbreak of the Civil War in 1861. That means the current stock and tech bubbles are likely to last longer than most investors expect.

 

  1. Bubbles can be independent of the overall economy. Yes, the burst of a Bubble can sometimes trigger a widespread economic meltdown; as the Great Stock Market Crash of 1929 and the mortgage bubble of 2007 did. Yet a bubble’s burst can have little or no effect on the overall economy. Neither the Black Monday Crash of 1987 nor the Florida Land Bubble of the 1920s, led to an overall economic collapse. The dot.com bust of 2000 was actually followed by an economic boom.

 

  1. A bubble can only cause a widespread crash in a weak or bad economy. In a healthy economy money simply flows out of the bubble market and into something else. As founds flowed from stocks to real estate in the early 2000s, and back into stocks in recent years. A crash only occurs when the money has nowhere else to go. Therefore a bursting bubble is often a prelude to the real collapse. For example both the dot.com bust and the Florida Land Bubble were preliminaries to larger catastrophes a few years in the future.

  1. A bubble or a bursting bubble may not be indicative of the wider economy. The Black Monday Crash had little effect because the underlying U.S. economy was in great shape. The 1929 Crash led to catastrophe because the economy was already on shaky ground.

 

Therefore bubbles are not necessarily destructive and not always bad. The dot.com bubble raised a vast amount of capital and laid the ground work for today’s internet and tech boom. If it was not for the dot.com bubble, Amazon and all the jobs it is creating at those fulfillment centers probably not exist. The railroad bubbles of the 19th Century created the modern United States and United Kingdom.

The moral of the story is to stay away from bubbles but never read too much into them. Always remember that at the end of the day, a bubble is nothing but a bunch of fools wasting their money on an overpriced asset. A bubble is simply normal human behavior not necessarily a sign of the apocalypse.

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