Financial Bubbles

By: James Gallagher, Fall 2013 Student Intern

tulipsIn the late 14th century, tulips were first introduced to Holland.  Within thirty years these flowers became so popular that the owner of a single bulb could trade it for a whole house.  However, in 1637, people began to realize that tulip bulbs were trading high above their actual value and the bulbs began to flood the market, driving the prices down until the only thing one could purchase with a tulip was an onion.  (Today you can buy 20 tulips for $45 online).

The Tulip Craze is one of the more famous financial bubbles in history. You may think that society is more sophisticated today and would never allow such a bubble.  Today’s technology may actually allow bubbles to grow faster as people get caught up in the next big trade. 

Bubble Formation

bubbleA financial bubble is created when a certain kind of stock or commodity begins to trade at levels drastically greater than its fundamentals suggest.  Bubbles are a product of human belief that a product or stock will continue to increase in value long into the future.  Therefore, buyers believe they should purchase the product now no matter what the cost.  As more and more people purchase the stock or commodity the higher the price rises.

Bubbles form from a combination of different factors. However, many of those factors relate to the relationship of humans to one another.  Robert Schiller, a Yale economist, claims bubbles are created due to irrational exuberance.  Essentially, this is a theory that news of a stock or commodity increase leads to more purchases and therefore more excitement concerning to stock.

For example, when people see their friends making a lot of money on a stock, they want to “get rich” too. So they buy the same stock.  This mentality is shared across millions of investors, including professional investors who control millions, if not billions, of dollars.  As more people continue buying this stock, the value continues to increase, creating a price that is not backed by the revenue and expenses of the company.

The Tech bubble of the late 20th century displays this type of herd mindset.  In the late 1990’s new “dot-com” companies popped up everywhere.  This was the first time the internet was used for commerce and investors were excited.  Companies that conducted business over the internet or made products for the internet saw incredible investment.  So much so that the companies often traded at much higher prices than their revenues suggested they should trade. Often times stocks were trading at high levels without ever creating revenue.

The Bubble Bursts

When investors start to lose enthusiasm over a stock, they begin to sell.  As more and more people become bearish on a stock, the price begins to decrease rapidly.  Prices start to decrease often a lot faster than the prices went up.  When the bubble “bursts” the stock is often left in tatters.

stock lossesDepending what sector the bubble was in, the rapid fall of prices could have a broader impact than just in its sector.  For example, the housing bubble of 2007-2008 spread from a real estate to the rest of the economy creating the worst recession of my lifetime.  Bubbles can be large or small and can determine the profitability of a sector for years to come.

Protect Yourself from Bubbles

Understand why you are investing in a particular stock or commodity.  If you are just doing it because it is a hot topic or an acquaintance did well with it as an early adopter, you may be buying a stock just before its bubble bursts.  Before you buy, do your research and make sure the investment makes sense for you and your financial goals.