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What is an asset bubble?

Level:
AS, A-Level, IB
Board:
AQA, Edexcel, OCR, IB, Eduqas, WJEC

Last updated 26 May 2023

An asset bubble, also known as a speculative bubble, refers to a situation in which the prices of certain assets, such as stocks, real estate, or commodities, rise rapidly and significantly above their intrinsic or fundamental value. This upward price movement is often fueled by investor enthusiasm, speculation, and the expectation of further price appreciation.

Asset bubbles typically occur when there is a disconnect between the market price of an asset and its underlying intrinsic value. As more investors buy into the asset, demand increases, driving prices even higher. This positive feedback loop creates a self-reinforcing cycle, attracting more investors who hope to profit from further price increases.

Several factors contribute to the formation of asset bubbles:

  1. Investor Psychology: Investor sentiment and herd behavior play a crucial role in the formation of asset bubbles. As prices rise, investors may become driven by fear of missing out (FOMO) and exhibit irrational exuberance, leading to a speculative frenzy.
  2. Easy Credit and Excessive Liquidity: The availability of easy credit and excess liquidity in the financial system can contribute to asset bubbles. When money is readily available and interest rates are low, investors have more capital to invest, which can drive up asset prices.
  3. Speculation and Overvaluation: Speculative trading and a focus on short-term gains can lead to overvaluation of assets. Investors may ignore or underestimate the underlying economic fundamentals and instead focus on potential price appreciation.
  4. Market Herding: Investors often look to the behavior of others to guide their own investment decisions. This herd mentality can amplify asset price movements, as investors tend to buy when prices are rising and sell when prices are falling, potentially creating a bubble.

Asset bubbles are generally unsustainable because they rely on speculative behavior rather than the underlying value of the asset. Eventually, the bubble bursts, leading to a sharp and significant decline in prices. This can result in financial losses for investors, disruptions in the economy, and potential systemic risks if the bubble affects the stability of the financial system.

Famous historical examples of asset bubbles include the dot-com bubble in the late 1990s, where stock prices of many internet-related companies skyrocketed before crashing, and the housing bubble that preceded the 2008 financial crisis, where rapidly rising housing prices eventually collapsed, leading to widespread economic repercussions.

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