Article edited by Lorenzo Pasinato
Introduction
In the economy, whether modern or ancient, it happens, has happened, and will happen that an investment can collapse at any moment. This can happen even when it is fervently supported by its supporters. But what are the causes and what is behind the logic of a bubble bursting? And above all, how do they burst, if an instant before we are faced with investments that are capable of making themself seem so unsinkable?
What is a bubble?
Some scholars agree that bubbles do not actually exist, or rather there are no such economic phenomena that can justify the existence or presence of certain market failures defined by the term “bubble.” But what is meant by a market bubble? The definition given is: “deviation from a fundamental market value.” Bubbles are an extreme market fluctuation due to the irrationality of investor’s behavior. Generally, a crisis is generated from the disruption of the normal market trend, specifically from an imbalance in an economic cycle; similarly, bubbles can be responsible for the disruption of the market trend and certainly contribute overwhelmingly to the creation of crises.
It is quick to define bubbles as an anomaly of the system, but they are actually not an endemic element of the capitalist system. Bubbles occur in case there is a significant increase in the number of investors in an asset. However, investors do not usually make a proper assessment of the investment and are distinguished by being united by one specific aspect: irrationality.
Rational or Irrational?
Macroeconomics is a branch of economics that studies and specializes in explaining business cycles and their downturns, including the presence of market bubbles. Economic theory analyzes economic models on the assumption that the consumer is rational. But reality is much more complicated and is characerized by structures that can be hardly predicted by simple basic explanatory models. The hypothesis of “rational” expectations is contrasted with the hypothesis of “adaptive” expectations, according to which the values of certain variables in the future are extensions of the values of the recent past. Thus, the cliché that “the trend is your friend”, which reflects the idea that if prices have risen, they will continue to rise, turns out to be a constant thought for “irrational” investors.
There is a clarification to be made. The bursting of bubbles, though generally associated with irrationality or the tendency of mass thinking to speculate, does not require all individuals involved to be irrational. An irrational group of individuals can influence individuals who think rationally.
Possible traits of irrationality
In addition, according to scholars, the traits that determine how rational an individual is or acts are based on four aspects.
The first is the presence or absence of the phenomenon of “group thinking”, and whether the individual is at least influenced by it. The second, the most common option in practice, is the loss of contact with reality, that occurs slowly and gradually. The third possibility is the presence of mass hysteria: as the price of the asset under consideration increases, so does the propensity to profit and the feeling that one can have a substantial and decisive economic return. The fourth is presented as the “fallacy of composition”, meaning that the behavior of individuals in a group differs from the behavior of the group itself. The fifth version advocates a lack of proper market analysis in rational terms; in this sense there is a mismatch between the quality of reaction to a quantitative change in the market. The last, on the other hand, involves investors evaluating the market through the wrong model or considering ambigous information.
Stages of a bubble
There are basically five phases that mark the evolution of a bubble:
- Inception: investors are attracted to a new investment, and they firmly believe that this can be a major turning point in the market. One phrase that most distinguishes this juncture is: “this time it’s different” and a general reassurance is given.
- Boom: the price of the investment starts to get high. Everyone is talking about a potential opportunity, the information is in the public domain, and the investment attracts diverse investors of all types.
- Euphoria: the bubble registers its maximum expansion, and it seems that it may grow even more. This is the phase when investors are strictly euphoric and when the profit in addition to being at its maximum, seems to be continuously expanding and that nothing can stop this climb.
- Profit: more conscious investors decide to liquidate their positions, causing the bubble to rebound. Thus comes the closing of the first positions.
- Panic: the end of the bubble. The closing of the first positions also prompts other investors, the “late comers”, to liquidate their positions and to ignite races to close positions. The collapse of prices and the bursting of the bubble occur.
The case of “dot-com bubble”
To understand how a bubble works and how one bursts, it is useful to analyze one. In this case, the focus is on the dot-com bubble. In short, the dot-com bubble was characterized by a rise in stock markets fueled by investments in Internet and technology companies. It was born out of a combination of speculative investment and overabundance of venture capital earmarked for startups. In the 1990s, investors poured money into internet startups in the hope that they would be profitable. As technology advanced and the internet became commercialized, startups in the internet and technology sectors helped fuel the stock market surge that began in 1995. The subsequent bubble was formed by easy money and abundant capital. Many of these companies were barely making profits or even a significant product. However, they were able to carry out initial public offerings (IPOs). Their stock prices registered incredible values, creating a frenzy among interested investors; but, when the market peaked, panic broke out among investors. This led to a 10% loss in the stock market. Capital that was once easy to obtain began to run out and companies with millions in market capitalization became worthless in a very short time. By the end of 2001, a good portion of public dot-com companies went bankrupt.
Conclusion:
In conclusion, analyzing market bubbles allows us to better understand and comprehend the possible causes of an economic crisis. Bubbles highlight how irrational euphoria and abundance of capital can fuel the rise and fall of seemingly unstoppable markets. It is a warning about the danger of excessive speculation and the importance of rational investment assessment to avoid an economic disaster.
Bibliography:
Goldfarb, B., & Kirsch, D. A. (2019). Bubbles and crashes: The boom and bust of Technological Innovation. Stanford University Press.
Kenton, W. (n.d.). What is an economic bubble and how does it work, with examples. Investopedia. https://www.investopedia.com/terms/b/bubble.asp#:~:text=A%20bubble%20is%20an%20economic,or%20a%20%22bubble%20burst.%22
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