What Is a Bubble?

# What Is a Bubble? A bubble is a market phenomenon where asset prices rise far above their intrinsic value, driven by exuberant market behavior. The term reflects how prices inflate like a soap bubble—expanding rapidly and beautifully before inevitably popping. ## Key Characteristics **1. Price Disconnection from Fundamentals** During a bubble, traditional valuation metrics become increasingly irrelevant. Price-to-earnings ratios, price-to-book values, and discounted cash flow models are dismissed as "old thinking" that doesn't apply to the new paradigm. **2. Narrative-Driven Growth** Every bubble has a compelling story that explains why prices must continue rising. These narratives often contain a kernel of truth—the internet really did change the world, and housing really is a fundamental need—but they're stretched beyond reasonable bounds. **3. Self-Reinforcing Dynamics** Rising prices attract more buyers, which drives prices higher, attracting even more buyers. This feedback loop can persist far longer than skeptics expect, creating the infamous "climbing the wall of worry" phenomenon. **4. Widespread Participation** Bubbles reach their peak when participation extends far beyond traditional investors. When taxi drivers, hairdressers, and your neighbor at the barbecue start giving investment advice, the bubble is likely in its later stages. ## Why Bubbles Keep Happening Despite centuries of documented bubbles—from tulip mania in the 1630s to the dot-com crash in 2000—humans keep repeating the same patterns. Several factors explain this: - **Recency Bias**: We give more weight to recent events, forgetting distant crashes - **FOMO (Fear of Missing Out)**: Watching others get rich is psychologically painful - **Herding Behavior**: Safety in numbers feels comforting, even when the herd is wrong - **Cognitive Dissonance**: We rationalize our positions rather than admit mistakes - **Leverage**: Borrowed money amplifies both gains and the pain of holding through losses ## The Bubble Cycle Economist Hyman Minsky described how bubbles form through increasing speculation: 1. **Displacement**: A new technology, policy, or event creates opportunity 2. **Boom**: Prices rise as the opportunity becomes recognized 3. **Euphoria**: Caution is thrown aside as everyone wants in 4. **Profit-Taking**: Smart money begins to exit 5. **Panic**: The bubble bursts and prices collapse Understanding this cycle is the first step to recognizing bubbles before they pop.