Asset Bubbles: How They Form and How They Pop

An asset bubble occurs when the price of an asset—housing, stocks, gold, bonds, etc.—becomes over-inflated and unsupported by demand. The asset price rises quickly over a short period of time as investors move a large amount of their money to purchasing a particular asset class (i.e. real estate) and bid prices up beyond real, sustainable value.

Asset bubbles typically begin with a period of economic growth and optimism. During this phase, investors become increasingly confident in the potential for high returns and start pouring money into a particular asset class. The increased demand for these assets drives up prices. As prices continue to rise, more investors are attracted to the market, hoping to make quick profits. As more investors join in, demand for the asset further increases, resulting in inflated prices. Media coverage or speculative rumors can cause investors to make irrational decisions based on the fear of missing out.

One of the primary drivers behind the formation of asset bubbles is easy access to credit. When interest rates are low, borrowing money becomes cheaper, allowing more people to invest. As the demand for assets increases due to the availability of cheap credit, prices inflate rapidly. This can be observed in the housing market, where low mortgage rates can lead to a surge in real estate prices, creating a housing bubble.

Sooner or later, the market realizes that the prices of these assets have become detached from their true value. This realization triggers a change in sentiment, leading investors to decide to cash out and take profits, which can cause a rapid decline in prices. As the bubble bursts, panic selling ensues, resulting in a crash that can wipe out a significant portion of investors' wealth. The rapid decline in prices can lead to financial crises, economic downturns, and even systemic collapses. The bursting of the Dotcom bubble in the early 2000s and the subprime mortgage crisis in 2008 are prime examples of how asset bubbles can have far-reaching effects on the global economy.

How to protect yourself

Despite the intentions of government regulation and our ability to learn from history, asset bubbles are a part of our economy and financial marketplace. However, the ability to spot a bubble as it is forming will allow you to avoid the risky, irrational investing habits that leave individuals, and the economy as a whole, devastated.

Asset bubbles are marked by an irrational excitement and frenzied commotion to buy a specific asset, with most investors buying in large quantities. This rapidly drives up price, regardless of the natural flow and relationship of supply and demand for the product the asset is based on. Prices can increase for several consecutive years before it outstrips demand and the whole structure crumbles, so a bubble’s lifecycle isn’t necessarily set by a specific period of time. This can make it very hard to judge exactly when the burst will happen and how to take advantage of buying and then selling the asset for the best profit. There are, however, general rules of thumb that apply and indicate when an asset bubble is on shaking ground. With real estate, for example, if housing prices increase remarkably faster than rent prices, a bubble may be at fault.

There is a plan you can follow to avoid falling victim to an asset bubble, and it’s probably one you’ve heard many times before: keep a well-diversified investment portfolio with a balanced mix of assets. Consistently revisit your asset allocation to ensure it remains balanced. If you notice the trend of a bubble with an asset class you invest in, you can try and sell it for a profit, but beware of holding onto it for too long—the price could bottom out before you have the chance to sell. Before buying or selling in that asset class, it’s best to consult with a qualified financial advisor first. If you have extra funds to invest in an asset on the rise, only consider investing if you can afford to lose it all if you don’t sell before the bubble pops.