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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.

Perhaps the most alarming aspect of an asset bubble is that it behaves like a snowball, gaining momentum and speed and involving more and more investors the longer it grows. When an asset’s price increases significantly faster than the larger market, investors and speculators bid and buy up that asset, driving the price higher and attracting more investors. However, while prices are climbing, real-world value and demand aren’t.

Example

One of the most recent asset bubbles to affect millions of Americans was the housing bubble of 2006 that lead to the Great Recession of 2007–09. And it played out just like the description above.

On the heels of the dotcom technology bubble burst around 2000, hedge fund managers began moving their investments into mortgage-backed securities as these were considered “risk-free” securities—people will always want to and be able to buy a house, right? As the demand for mortgage-backed securities grew, those who created the supply (i.e. mortgages)—namely banks—were eager to create them, giving mortgages to anyone and everyone—even those who couldn’t really afford the payments. They severely relaxed their lending standards, allowing for riskier and riskier mortgages (called subprime mortgages) to be given out to feed the demand for mortgage-backed securities.

With more and more people being approved for high-value mortgages, the demand for houses soared. Homebuilders were constructing entire housing developments at breakneck speed to meet the demand for new, high-end housing. But like any ride, the housing train eventually came to screeching halt when those subprime mortgages went into default, people lost their homes and moved out, and the supply of houses quickly overshot the demand. Housing prices fell because there were no longer buyers for them, and the “safe” securities that were comprised of bundled subprime mortgages lost their value as families defaulted on mortgage payments. The bubble burst.

Other asset bubbles in the past 20 years include gold, the U.S. dollar, Bitcoin, oil, websites (the dotcom bubble), U.S. Treasury notes, and the stock market. One that many financial analysts and investors are now keeping their eye on is the possibility of a college/student loan bubble or auto loan bubble.

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 base 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.