Too embarrassed to ask: what is a bubble?

Even if you don’t pay a lot of attention to markets or investing, you’ve probably heard the term “bubble”. But what exactly is it?

Even if you don’t pay a lot of attention to markets or investing, you’ve probably heard the term “bubble”.

The global property bubble of the early 2000s led to the sub-prime crisis. The dotcom bubble of the late 1990s led to the dotcom bust. The South Sea Bubble of 1720 cost Sir Isaac Newton millions of pounds in today’s money.  

But how exactly can we define a bubble?

Given that it’s probably one of the most famous terms in investing, it’s somewhat ironic that the correct answer to that question is “we can’t”.

There is no specific recognised definition of an investment bubble. 

This is partly because financial markets theory is built on models which assume that markets are rational. Most people know that this isn’t the case in practice, but it still makes it difficult to slot an emotionally-driven phenomenon like a bubble into existing theories. 

However, it’s also because pinning a bubble down is hard. 

Does a bubble just mean a high valuation? Well, no, it’s more than that. 

Technology stocks might look expensive today. But they look positively tame compared to their valuations in the dotcom era. And US stocks have looked expensive on most valuation measures for at least five to ten years now. Yet there’s no sense of the wild optimism and “fear of missing out” that characterises the most infamous bubbles.   

If anything, it’s this sentiment aspect that separates a genuine bubble market from a merely expensive one. Every bubble starts with a good fundamental story – often related to technological change, or to a genuine supply shortage of the bubble asset.  

As the asset rises in price, and the story becomes more widely known, there’s a sense of almost-manic desperation to get onboard. The price rockets, then rockets some more, as more and more investors are sucked in.

The investors and company insiders who got in early on see that the high prices are no longer justified by what’s happening on the ground. They start to sell even as more naive buyers keep coming along to add more fuel to the fire.  

But eventually, there are no new buyers left to buy, and the bubble bursts. The latecomers lose the lot. 

This leads us to the final aspect that makes bubble spotting so tricky – you can only know for sure that it was a bubble, after it has popped. 

For more on bubbles and how to profit from them, subscribe to MoneyWeek magazine

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