In any economy, it is not uncommon for asset prices to rise and fall. But when an asset’s price increases to a drastically high level in a brief time, and there is a short-lived spike and dip, it causes a negative after-effect on the investors and the economy. The pioneers of economics have termed this situation as a bubble. A bubble is a phenomenon used to describe the exponential rise and fall of a specific asset in the stock market, industry market, credit market, or commodity market. Stock markets especially are (in) famous for their high-risk and ever-fluctuating nature, despite which, see a lot of investors. However, sometimes investors can fall and have fallen prey to, in the past, stock market bubbles that cause immense financial loss. That is why it becomes crucial for investors to learn what stock market bubbles are and identify and exit from one in time.
The 5 stages of a stock market bubble
A stock market bubble refers to the rapid increase in stock or share prices of a particular asset or company. It occurs when investors become enthusiastic and invest in a specific stock causing a spike in the stock rate. The asset rate surpasses its original value due to a heightened buzz of speculation around it in contrast to the asset’s intrinsic value. The word bubble is used to describe the situation as the majority of investors are unable to predict the asset’s downfall and stay in a bubble about the potential profits they can accrue. Hyman Minsky – a revered American economist, categorized a stock market bubble into 5 stages:
Stage 1 – Displacement:
This stage is set off by a collective interest or enthusiasm in a particular asset that investors believe will give high returns. The onset of this belief gets sparked by a promising event, innovation, change, or low stock prices, which impresses potential investors and makes them eager to buy stocks, paving the way for a collective momentum.
Stage 2 – Boom:
While the initial purchasing of stocks is low, the increased buzz around the asset, through media or word of mouth, drives others to join the bandwagon and buy the concerned asset’s stocks. At this stage, speculation more than a logical assessment of the asset’s original value fuels prospective investors to buy stocks. A herd mentality develops with more and more people wanting to not miss out on a highly beneficial investment opportunity. Hence, the boom in stock sales.
Stage 3 – Euphoria:
At this stage, the price of the stock peaks to an extremely high value despite a big difference in its original price. Investors rush to buy stocks before others can, which increase their demand and associated stock price.
Stage 4 – Profit-Taking:
The extreme skyrocketing of stock prices ultimately leads to its downfall. Then arrives a point where investors become wary of paying the exorbitant stock price. This can be due to any reason, from an awareness of the true asset value to negative media coverage of the asset. Some of the investors foresee the stock’s downfall. They begin to sell their stocks; in the hope of securing their profits and avoiding catastrophe.
Stage 5 – Panic:
When a few investors begin to sell their stocks, others follow suit due to the fear of losses and start to sell off their bought stocks. There is an atmosphere of panic and frenzied trade-offs, with no one wanting to be the last shareholder of the rapidly declining asset. The initial excitement of buying gets replaced with the hurry to sell, bursting the stock market bubble.
How to identify and avoid the repercussions of a stock market bubble?
There are no exact reasons for the onset of a stock market bubble, but they can all be pinpointed to the extreme popularity of a specific asset. To avoid getting sucked into stock market bubbles, it is crucial to conduct a practical analysis of the asset’s fundamental value and keep away from falling into the trap of speculation. It is also wise to consult a financial expert and do your research before finalizing an investment. Remember to always have a long-term approach and diversify your portfolio to suit your risk appetite.
