What is Bubble Theory?

The bubble theory refers to a financial hypothesis involving a rapid upward movement of security prices followed by a sudden sharp price fall. This forces investors to withdraw from overvalued assets. The assumption is that the prices of assets or stocks will shoot up to a point where making reasonable valuation will be difficult. It will then lead to investor withdrawal for such assets or stocks.

How Does Bubble Theory Work?

Bubble theory includes any class of assets that increases beyond its true value. They include assets such as commodities, securities, the housing market, stock markets, economic and industrial sectors. Bubbles create a dangerous situation for investors because they happen to remain overvalued for an uncertain period before the prices in the market crash. It reaches a point when the bubbles will eventually burst. It is at this point when the market witnessed a decline in prices and stabilizing at more reasonable valuations. It usually results in a significant loss for a good number of investors.

Excess demand results in a bubble. The bubble is usually caused by motivated buyers leading to a rapid increase in prices. An increase in prices attracts the attention of more people, hence leading to more demand. It is at this point that investors notice how unsustainable the situation is forcing them to start selling their securities. The process reverses the moment a critical figure of sellers emerges. As usual, those investors who purchase at the highest prices will definitely experience the biggest loss during bubble bursts. Generally, it is difficult for investors to identify bubbles as they form and grow. Bubbles can only be beneficial if investors are able to identify them before they burst. Early identification of bubbles helps investors to withdraw before the losses accumulate. It is the reason why most investors spend a good amount of their time trying to detect the bubbles movements.

The Origin of Bubbles

The term bubble popped up officially for the first time in 1720. The economic term was passed by the British parliament as the June Bubble Act. The purpose of the legislation was to control how companies raise capital and to also inhibit corporate fraud. However, the act ended up contributing to the first major market crash in England (the South Sea Bubble). Other historical bubble examples include:

• The 1930s recession
• The dot.com crash in 2001
• The 2007-2008 subprime mortgage crisis