What is a Bubble?

A bubble is a rapid expansion in one sector of the economy often due to a perceived game-changing shift in the fundamental way of doing business. As a result of the shift, stock prices or asset prices increase rapidly. A recent example is the Internet (dot-com) bubble in the late 1990s and early 2000s.

New businesses were just created to leverage and utilize the communication power of the Internet. The talk was that, "this changes everything." And "this time it's different, business will never be the same again."

As a result of the excitement and euphoria surrounding these new Internet-only companies, many of which no longer exist, some investors made a fortune investing in their initial public offerings (IPO's) and everybody was looking to get rich in the next big thing, hoping to find the next General Motors or the next General Electric.

As a result, the market value of many dot-com companies were incredibly inflated even though many of them never even turned a profit! When people began to lose confidence in these stocks, a correction occurred and prices returned to a more natural, less inflated level. This correction is often referred to as bust or crash.

The chart below is of the NASDAQ which carried most of the public stocks of the Dot-com era:

Click for larger Chart

Other examples of financial bubbles in history include:

1. The tulip mania in Holland in the 1630's - that's right - tulip flowers. One bulb became worth the salary of 10 years of service by a skilled tradesman.
2. The South seas bubble of the 18th century where companies in the newly colonized South American countries were bid up to enormous amounts.
3. The 1920's U.S. stock market mania where leverage was used to extreme levels which pumped more money into stocks. The result was the stock market crash of 1929 and the Great depression of the 1930's.
4. Japan's stock market in 1980's soared to incredible highs and 20 years later is still more than 50% lower than the all-time high.

One common characteristic of bubbles is that everyone in a society, not just the wealthy, are all investing in the same thing, believing that they can't lose money. This is what causes prices to skyrocket, until no one is left to buy and push up prices even further.

However, in all financial bubbles, the high prices eventually dissolve, collapsing in on themselves and causing huge losses to investors who put up money near the top.

There is a famous story from the Depression: one day a stock broker got his shoes shined on the street. The boy shining his shoes gave him a "hot stock tip." That's when the broker knew that it was time to sell all his stocks.

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