A market bubble occurs when the price of an asset rises significantly above its intrinsic value, driven not by fundamentals but by exuberant investor behaviour. These periods are marked by rapid price increases, widespread optimism and a growing disconnect between asset valuations and their underlying economic reality. Eventually, this misalignment becomes unsustainable and the bubble bursts – often with sharp and destabilising consequences.
Understanding how bubbles develop, the psychological and economic forces behind them and the typical lifecycle of a bubble can help investors recognise warning signs and contextualise historical events.
THE NATURE OF MARKET BUBBLES
Market bubbles are characterised by unsustainable growth in asset prices. While financial markets often experience periods of volatility and strong performance, bubbles are distinct in that prices rise far beyond levels supported by fundamentals such as earnings, dividends or economic output.
Bubbles are not confined to one type of asset. They can occur in equities, property, commodities, currencies or even in sectors within a broader market. What unites all bubbles is the tendency for prices to become detached from rational valuation models due to speculative demand and herd behaviour.
HOW BUBBLES FORM AND GROW
Bubbles typically begin with a displacement: a catalyst that introduces a new opportunity or shift in expectations. This could be a technological innovation, regulatory change or a period of unusually low interest rates. The initial enthusiasm attracts early investors who genuinely believe the asset is undervalued.
As the boom phase begins, more participants enter the market, often motivated by rising prices rather than fundamentals. Media coverage and positive sentiment fuel further inflows. At this stage, demand increases prices and higher prices attract more demand – a self-reinforcing cycle.
This accelerates into euphoria, where caution is abandoned. Investors increasingly disregard risk, assuming that prices will continue to rise indefinitely. Traditional valuation methods are dismissed and leverage often increases. Assets are bought for their price momentum rather than their long-term value.
Eventually, some investors begin profit-taking. The most informed participants start to exit their positions, having recognised the unsustainable nature of the rally. This selling pressure may not be immediately obvious, but it weakens the price momentum.
When prices begin to fall meaningfully, panic sets in. Confidence collapses and widespread selling drives prices down rapidly. As investors rush to exit, liquidity can dry up and losses compound. The bubble bursts, often erasing much of the gains made during the boom and euphoria phases.
OVERVALUATION VS SPECULATION VS BUBBLE
Not every overvalued market is a bubble. Valuations can exceed historical averages for extended periods due to low interest rates, earnings growth or changing investor preferences. Overvaluation becomes a bubble when price increases are driven more by investor behaviour than by fundamental changes.
Speculation also plays a role but does not always lead to a bubble. Investors may speculate based on expected developments, such as regulatory changes or new technologies. However, when speculative activity dominates the market and rational analysis is replaced by hype, the risk of a bubble rises.
In a true bubble, prices are driven by unrealistic expectations of future growth or value. Buyers enter the market primarily because they expect to sell to someone else at a higher price, not because they believe the asset offers long-term value. This distinction is critical in understanding why bubbles are inherently unstable.
PSYCHOLOGY AND FEEDBACK LOOPS
Investor psychology is a central component of bubble formation. Fear of missing out (FOMO), overconfidence and the influence of social proof all contribute to a willingness to ignore risk. As more people invest, it reinforces the perception that an asset is a guaranteed winner.
This behaviour creates positive feedback loops. Rising prices attract more attention and participation, which further pushes prices up. Market narratives emerge to justify high valuations and dissenting voices are often dismissed or ignored. When price action becomes the justification for further investment, markets enter dangerous territory.
EXAMPLES OF DISPLACEMENT EVENTS
Displacement events often come in the form of major economic shifts. The arrival of railways, the internet and blockchain technology each led to significant investor interest. Low interest rate environments have also played a part, as they push investors toward riskier assets in search of returns.
These events are not inherently negative. In fact, many of them are underpinned by genuine innovation or macroeconomic change. However, when market enthusiasm outpaces the ability to accurately assess value, bubbles can form around even legitimate developments.
WHY BUBBLES BURST
The collapse of a bubble is often abrupt because its growth is based on fragile foundations. Once doubt enters the market, the selling can become self-reinforcing. Investors who relied on rising prices to justify their positions begin to sell, prompting others to do the same. Leverage compounds the problem, as forced selling intensifies downward pressure.
The bursting of a bubble can cause widespread financial damage. Individual losses may be severe, but broader consequences can follow if the bubble is large enough to affect financial institutions or economic confidence. In some cases, policymakers intervene to stabilise markets or implement reforms.
BUBBLES IN RETROSPECT
After a bubble bursts, hindsight often makes the signs seem obvious. However, identifying a bubble in real time is difficult. Markets may appear overvalued for extended periods without crashing and some assets continue to perform well even after periods of speculative excess.
Historical analysis can help investors better understand the characteristics of bubbles. While no two bubbles are identical, they often follow similar patterns of displacement, acceleration and collapse.
CONTEXT FOR TODAY’S INVESTORS
Bubbles are not confined to the distant past. Contemporary markets continue to experience episodes of speculative activity, particularly in emerging sectors or during periods of low interest rates and high liquidity. The growth of online trading platforms and the speed of information sharing have accelerated the pace at which speculative behaviour can spread.
For investors, understanding the anatomy of a bubble is essential. Recognising the difference between genuine growth and momentum-driven speculation can help protect against major capital losses. While avoiding bubbles entirely may not be possible, remaining disciplined and informed is key to navigating these cycles effectively.
This Trustnet Learn article was written with assistance from artificial intelligence (AI). For more information, please visit our AI Statement.