Financial bubbles cannot be understood solely through charts, ratios and macroeconomic indicators. At their core, bubbles are a behavioural phenomenon. They occur when investor psychology drives asset prices beyond levels that fundamentals can support. While market conditions, liquidity and innovation may help create the conditions for a bubble, it is human behaviour – shaped by emotion, bias and social influence – that ultimately fuels its ascent and collapse.
The field of behavioural finance offers a framework for understanding why rational investors sometimes act in irrational ways. In the context of bubbles, several recurring behavioural patterns become particularly relevant.
HERD BEHAVIOUR AND SOCIAL VALIDATION
One of the most powerful forces in financial markets is herd behaviour – the tendency of individuals to mimic the actions of a larger group. Investors often assume that if many others are buying a particular asset, they must have good reason to do so. This perception creates a feedback loop where rising prices attract more buyers, which in turn pushes prices even higher.
Herding is not necessarily irrational in every context. In situations of uncertainty, using the actions of others as a reference point can be a practical shortcut. However, during a bubble, this behaviour leads to distorted market signals. Prices rise not because of improving fundamentals but because others expect them to rise, a dynamic that weakens the relationship between value and price.
This form of collective behaviour has been observed in virtually every major bubble – from the South Sea Company in the 18th century to internet stocks in the 1990s and cryptocurrencies in recent years. In each case, many participants joined the rally because everyone else appeared to be doing the same.
FEAR OF MISSING OUT (FOMO)
Closely related to herding is the fear of missing out or FOMO. As asset prices surge, investors who initially stood on the sidelines may begin to feel left behind. Watching others profit while one’s own portfolio remains flat can create intense pressure to participate, even when the fundamentals seem questionable.
FOMO is particularly potent during the later stages of a bubble, when media coverage, social media posts and anecdotal success stories dominate public discourse. Investors may disregard risk and valuation concerns, motivated instead by the desire not to miss a rare opportunity.
This behaviour often leads to late-stage buying, when prices are already stretched. Participants may convince themselves that they are investing based on careful analysis, but their timing is typically shaped more by emotion than by logic. When the bubble bursts, these investors are often among the hardest hit, having entered at or near the top.
OVERCONFIDENCE AND ILLUSION OF CONTROL
Overconfidence is another common behavioural bias that contributes to speculative excess. Investors tend to overestimate their ability to predict market movements, select winning assets or time their entry and exit points effectively. This misplaced confidence can lead to riskier positions, excessive trading and reduced diversification.
During a bubble, overconfidence is often reinforced by early success. As prices rise, even poorly informed investment decisions can appear to be clever strategy. This fosters a false sense of skill and control, encouraging investors to take on more risk than they would under normal conditions.
The illusion of control – the belief that one can influence outcomes in a fundamentally uncertain environment – also plays a role. Investors may attribute gains to their own insight while attributing losses to external factors. This asymmetrical thinking impairs the ability to learn from mistakes and encourages the persistence of flawed strategies.
NARRATIVE-DRIVEN INVESTING
Narratives shape how investors interpret information. A compelling story can justify high valuations, attract capital and mask fundamental weaknesses. In the context of a bubble, narratives often centre around themes of technological revolution, economic transformation or the emergence of a new paradigm.
These stories do not need to be entirely false to be effective. Often, they contain elements of truth – such as real innovations or shifts in consumer behaviour – but they extrapolate those truths into unrealistic expectations. Investors who become emotionally invested in the narrative may disregard contradictory evidence or dismiss concerns as outdated thinking.
The dot-com bubble, for example, was driven by the belief that the internet would change the world – and it did. However, that belief led many to assume that all internet-related stocks would become profitable, regardless of their business models. More recently, narratives around blockchain, electric vehicles and artificial intelligence have shown similar patterns of rapid capital inflow based on optimistic projections.
Narratives are particularly influential because they offer simplicity in the face of complexity. They reduce uncertainty, give investors a sense of purpose and help explain volatile price movements. When widely adopted, these stories can become self-fulfilling for a time – until the underlying assumptions break down.
THE AMPLIFYING EFFECT OF SOCIAL MEDIA
In recent years, social media has become a powerful accelerant for speculative behaviour. Platforms such as Twitter, Reddit, YouTube and TikTok have allowed investment narratives and crowd sentiment to spread with unprecedented speed. Retail investors, once fragmented and isolated, can now act in concert, often coordinating trades or sharing ideas in real time.
During the 2020–2021 surge in so-called ‘meme stocks’, social media played a central role. Platforms amplified enthusiasm, vilified dissent and encouraged users to hold or buy certain assets, often with little regard for fundamentals. Viral content, emotional appeals and a sense of collective identity transformed investing into a social movement for some participants.
While these platforms can provide valuable information and democratise access to markets, they also magnify risk. Echo chambers, confirmation bias and the rapid spread of misinformation can distort perception and encourage reckless behaviour. For younger or less experienced investors, the line between entertainment and financial decision-making can become blurred.
LOSS AVERSION AND THE RELUCTANCE TO EXIT
Another behavioural trait that shapes bubble dynamics is loss aversion – the tendency to feel the pain of losses more acutely than the pleasure of gains. Once investors have committed to a position, they may become reluctant to sell even when warning signs emerge. Selling at a loss requires acknowledging that a decision was mistaken, which many investors find psychologically difficult.
This inertia often contributes to prolonged holding during the early stages of a downturn. Investors may believe that the decline is temporary, that the asset will recover or that they can exit at a better price. By the time they accept the change in market conditions, losses may be far more severe.
Loss aversion can also lead to averaging down – a strategy in which investors purchase more of a falling asset in the hope of reducing the average cost. While this can work in specific circumstances, in a collapsing bubble it often results in compounding losses rather than recovery.
THE ROLE OF GROUPTHINK AND NARRATIVE CONFORMITY
In group settings, especially online, individual critical thinking can give way to groupthink – a desire for consensus that suppresses dissent. Investors may avoid questioning prevailing narratives to maintain group harmony or avoid social rejection. This behaviour reinforces optimism and discourages the expression of caution or scepticism.
As a result, potentially valuable counterarguments are dismissed or ignored. Analysts or commentators who raise concerns may be labelled as pessimists or contrarians, particularly if their warnings challenge the dominant narrative. In some cases, sceptics are personally attacked or excluded from discussions.
This form of narrative conformity limits open debate and reduces the diversity of viewpoints in a market. In such environments, risk builds silently, unnoticed by those who have become emotionally committed to the prevailing story.
IMPLICATIONS FOR INVESTORS AND MARKET STABILITY
Understanding investor behaviour is essential for interpreting market dynamics, particularly during periods of rapid price appreciation. While fundamentals, interest rates and macroeconomic conditions all influence asset prices, behavioural forces can override rational analysis and create conditions for bubbles to form.
For long-term investors, awareness of these psychological tendencies can serve as a form of risk control. Recognising FOMO, questioning popular narratives and maintaining valuation discipline may help mitigate the temptation to follow the crowd.
Equally, policy makers and regulators must consider behavioural factors when assessing financial stability. Tools such as macroprudential regulation, financial education and market transparency can help reduce the likelihood that emotional decisions will lead to systemic problems.
Although markets will always be influenced by human behaviour, a deeper understanding of psychology allows investors to better navigate its effects. Rationality may be elusive in the short term, but disciplined thinking, informed by behavioural insight, can provide a more stable foundation for long-term decision-making.
This Trustnet Learn article was written with assistance from artificial intelligence (AI). For more information, please visit our AI Statement.