When investors become irrational, you can have an economic bubble.
- Economic bubbles have occurred throughout history.
- Economic bubbles usually have four stages.
- Knowing when to avoid investing and when to invest makes you a savvy investor.
When a particular asset is valued significantly higher than its fair value, it is known as a “bubble”. And simply put, economic bubbles burst. At some point, it seems everyone admits. “Yeah, we knew it was overrated.”
1. Balloons are nothing new
As long as there has been money to be made, there have been economic bubbles. There are many historical examples. Here are two of them.
The Dutch are known for their love of tulips and have poured their hearts and souls into developing many different varieties. At first it was wealthy Europeans who became lovers of tulips. By the mid-1630s, the tulip craze took off, and even middle-class and poor families wanted to plant the bulbs.
With so many people vying for the bulbs, the tulip market ran wild, reaching its peak in 1636. Now this is where things get interesting. As tulips became more expensive, people began to think: “Hey, if I can get a light bulb at a fair price, I can resell it at a higher price and get rich.”
People have mortgaged their homes and businesses just to buy bulbs for resale. And what they were willing to pay for one Viceroy tulip bulb got out of control. So many people bought into the myth that tulips were worth a king’s ransom that when the bubble finally burst, the Netherlands was plunged into economic depression.
Take: Just because others say an asset is hot doesn’t mean it will be a money maker.
Dot Com Bubble (1990s)
One bubble that may be more familiar to modern readers is the Internet or dot bubble of the 1990s. As the Internet became available in consumers’ homes and the technology industry was poised to take over the world, investors were required to get in on the action.
The more people invested in dot com stocks, the more others developed FOMO (fear of missing out). Pretty soon people who had no interest in technology were throwing all the money they could find into the industry. Tech stocks soared on the Nasdaq, with many convinced they had invested in the right thing.
Soon stocks were trading for much more than they were worth, and when the bubble burst and stock values crashed, millions lost money.
Take: Economic bubbles have risen and burst again and again. Because we know it’s possible for any asset to be overvalued, it’s up to us to use our common sense when it seems like the rest of the world is going crazy.
2. There are four stages
Investors who make money in an economic bubble are those who get in early and then sell before the bubble bursts. Unfortunately, it is impossible to time the market precisely. However, understanding that the typical bubble consists of four stages can help you understand when it’s time to show yourself to the door.
First phase: Privacy phase
Few people see promise in a new investment opportunity.
Second stage. Awareness stage
More people want in and prices go up. The media gets their attention, and the investment becomes further exposure.
The third stage. phase of obsession
Prices continue to rise, hype grows, and the potential for easy money seems endless. Investors become irrational, ready to pay anything to get into the “sure thing”.
Fourth stage. blowing phase
There is a kind of cooling. Suddenly people are admitting that prices are out of control and that the asset has an unrealistic value. The media is becoming negative. Buyers lose interest, the bubble bursts, and prices plummet.
Take: Avoid the rush to buy during the mania phase. You will most likely pay.
3. There is still money to be made
Overzealous investors explain why bubbles form. However, what goes up must come down, and this is where the smart investor picks the best deals. When buyers lose interest and investors sell, you’re likely to find bargain basement prices.
Let’s say the bubble that burst was in the housing market. Prices are falling and you understand = you can get a fair deal on a property to rent or flip. Bursting the bubble doesn’t necessarily mean the asset was a stinker. It just means that people have let their emotions (and greed) drive their decision making for a while.
Take: Once the bubble bursts, examine the asset from all angles to determine if it is a good investment at a new, lower price.
Few things in life are all bad or all good, and the same is true of economic bubbles. Knowing how to avoid the hype and capture a bargain basement price for your investment is your superpower.
Warning: the highest cashback card we’ve seen now has a 0% investment APR through 2024
If you use the wrong credit or debit card, it can cost you serious money. Our expert likes this top pick, which has a 0% intro APR until 2024, a crazy cash-out rate of up to 5%, and somehow no annual fee.
In fact, this card is so good that our expert even uses it personally. Click here to read our full review for free and apply in just 2 minutes.
Read our free review