Financial Bubbles: Simple Explanation Of What Is It, How To Recognize It, and How Does It Happen

Financial bubbles appear and then burst in almost any financial market. To avoid the final stage of the bubble , the “burst” or panic stage, you need to know the five stages of a financial bubble and why these bubbles occur in the first place.

The Five Stages of a Financial Bubble.

The best way to describe a financial bubble is by the five stages all financial bubbles go through. All financial bubbles start with a rapid escalation of a market value a financial asset and ends with a crash or a “bubble burst”. The American economist Hyman P. Minsky identified through his research the five stages in a typical credit cycle. These five stages can be observed for any financial bubble to include stocks, financial assets, credit, or commodities. See five stages of a financial bubble below:

1. Displacement. Investors or buyer begin to notice a new paradigm such as an innovative new technology or historically low interest rates.
2. Boom. The financial asset attracts widespread media coverage. Investors fear that they may miss out on a once-in-a-lifetime opportunity. Speculation begins.
3. Euphoria. Investors throw caution to the wind and the asset’s price skyrockets. Investors believe that no matter how high prices go that there will still be buyers willing to pay more.
4. Profit-Taking. Some investors start selling and take profits. These investors heed the warning signs that the bubble is about to burst.
5. Panic. As some point, there is usually a minor event that pricks the bubble. Prices rapidly reverse course. Investors panic. Some faced with margin calls will liquidate at any price. As an example of a financial bubble burst, this happened in October 2008 when Lehman Brothers declared bankruptcy thus triggering the Great Recession.

See Investopedia’s 5 Stages of A Bubble for more information on the five stages of a financial bubble. Also, see TheBalances’s Asset Bubbles: Causes and Trends for more examples of financial bubbles.

What Types of Financial Assets are Vulnerable To Bubbles?

All types of financial assets can have sudden price surges and get caught up in a financial bubble. This includes: 

• Financial Equities and Securities.  This includes stocks or any financial assets that an investor owns.
• Financial Assets. This includes real estate, currencies, and cryptocurrencies.
• Forms of Credit. consumer or business loans, debt instruments, and other forms of credit.
• Commodities. This includes traded commodities such as gold, oil, industrial metals, or agricultural crops. 

What Causes Financial Bubbles?

There are many causes for financial bubbles, but these causes do not necessarily result in a financial bubble. These causes can be thought of as “incubators” that may be the beginnings of a financial bubble. Below are the major reasons for a financial bubble:

• Low Interest Rates. This tends to encourage borrowing for spending, expansion, and investment.
• Foreign Investment and Purchases. Again, low-interest rates or other favorable conditions in a nation may encourage an influx of foreign investment and purchases.
• New Product or Technologies. This can spur demand and higher prices (demand-pull inflation).
• Supply Chain Shortages. If assets are in short supply this causes prices to rise. This could be because of raw material shortages, supply chain disruptions, or a growing economy. If price are rising across many sectors of the economy, then inflation will also occurs. 
• Government Intervention. This is not usually done intentionally, but many times there are unintended consequences to government intervention. As example, a government offers tax credits for electric cars and prices go up for electric cars and its components.
• Market Psychology. Just plain irrational thinking or expectations of rising prices can trigger higher prices for a financial asset. These market psychology behaviors include:
  • Herd Mentality. It is human to follow the crowd, especially when there is a positive expected outcome. This behavior can also be called Fear-of-missing-out (FOMO).
  • Hindsight Bias. Investors often justify their decisions based on one or two successful examples in the industry or from history (e.g. Amazon, Bitcoin) while little attention is given to failed investments (e.g. pets.com or many other cryptocurrencies).
  • Confirmation Bias & Cognitive Dissonance. The investor only accepting information that confirms an already-held belief, and ignoring anything that doesn’t.
  • Overconfidence. Some of us are just overconfident and think we can “beat the market”. We count our success to our own talent, and any failures are attributed to bad luck. This leads to high risk-taking as seen with compulsive gamblers.
  • Greater Fool Theory. This theory describes aspects of a late-stage bubble. Where people pay huge sums for already overvalued assets and believe that they will find a “greater fool” who will buy it for even more money
  • Economic Forcasts. If an economic forcast or expectations call for inflation, these expectation actually contribute to a rise in inflation.

See Investopedia’s 5 Steps of a Bubble, M1’s Understanding financial bubbles, asset bubbles, stock bubbles and the impact of demand-pull inflation, and MoreThanDigital’s Economic Bubble – Definition, Types and 5 Stages of Financial Bubbles for more details on causes of financial bubbles.