Uncovered: What is a bubble in the finance world?

Fsp Invest, 12 Nov. 2013

Tags: bubble, stock market bubble, what is a bubble, property bubble, tech bubble, financial market bubble, investing,

There's a lot of talk about bubbles around at the moment. Margin debt (the amount of money borrowed to buy shares) is at record levels. The S&P 500 looks expensive on long-term measures, such as the cyclically-adjusted price earnings ratio. And when you're starting to see record prices again on various stock markets around the world it always brings out the jitters. Read on to find out exactly what a bubble is…

For such an important market phenomenon, investors poorly understand bubbles, John Stepek in UK Money Morning explains…

That's partly because the dominant view of markets – the efficient market hypothesis – still has difficulty even accepting the possibility of their existence.

Put simply, and without all the academic fudging, the efficient market hypothesis argues that markets are priced perfectly. The wisdom of crowds means that all available information reflects in the share price. So the price is always 'right'.

If the price is always right, there can be no such thing as a bubble, because even apparently ridiculous valuations are always justified by the information available.

Clearly this is a world that would only make sense to an academic. It's obvious to anyone who cares to look that investors get carried away sometimes: The tech bubble and the US property bubble are just two recent examples in a long history of bubbles.

The tricky part is in pinpointing a bubble. But one of the warning signs is when people are investing in an asset class for all the wrong reasons.

An example of a bubble in action

A bubble normally starts with a 'good story'. For example, the internet is going to transform the world, save everyone a fortune, and make life more convenient. So buy internet stocks.

That's a good story. So people buy the stocks. They go up and up.

And gradually the story changes to: People are making money by buying internet stocks. So keep on buying them.

'Buy because it's going up' is not a great reason to buy any asset. But often it'll keep things going at this stage.

But the real warning sign comes at the 'resignation' stage. At this point, asset prices are at levels that are unprecedented. Anyone with a brain who's halfway honest can see that these things are expensive.

But there's a sense – particularly among the professionals - of "what else are you going to do? This stuff's going up, so I have to keep buying."

So you get a lot of stories about how 'it's different this time', or people desperately looking for elaborate ways to invest in the story that don't look quite as dramatically overvalued. You often see lots of new funds launching at this point in the cycle, to take advantage of investor interest in the sector.

So there you have it, what a bubble is.

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