What Is a Market Bubble?

market bubble can lead to fantastic profits for some traders and investors, while causing substantial losses for others. That's because, although a bubble means prices can continue to rise and rise to dizzying heights, it's ultimately an unsustainable phenomenon - eventually, the bubble goes *pop*.

Understanding market bubbles is important for any trader and investor, as you'll undoubtedly encounter them at times throughout your career.

Characteristics of a Bubble

Two of the key characteristics behind a bubble are usually speculation and hype. One person starts talking about how great an asset is, and soon enough, everyone is convinced that it's the next big thing. 

This can create a self-fulfilling cycle of positive sentiment and rising prices. As more and more investors buy the asset, its price rises, leading to a situation where the price becomes significantly disconnected from its underlying value. 

The diagram shows the different phases of a bubble. As the asset slowly increases before rapidly climbing higher, followed by the burst, where the price returns to the mean. Which part are most traders jumping in at? Probably around the mania phase! 

However, bubbles can last a long time, and that mania phase can go on for quite a while, meaning we don't just want to be jumping in against it. As the famous saying goes: "Markets can stay irrational longer than you can stay solvent."

Bursting the Bubble

When the bubble finally bursts, that usually means a massive decline at a rapid pace. Many people who bought into it during the mania phase can suffer significant losses. 

Many reasons could cause a bubble to pop, and this will depend on the specific asset. But the common link is that it will generally come from a big drop in demand. Some potential examples include:

Firstly, and perhaps most obviously, the asset becomes so overvalued that many buyers are unwilling to pay such a high price.

Secondly, the Fed could begin raising rates. That will make borrowing more expensive and could increase the cost of buying an asset, such as a home. It's also likely to impact economic growth as consumer spending falls. This leads us to the third potential reason, a recession. 

If a recession occurs, that could cause unemployment to increase and lead to less disposable income. That means less money is spent on assets like stocks.

The actual cause of a bubble popping can come from many factors, such as the ones just mentioned, and other challenging things to identify.  

Predicting a Bubble

Much of what we discussed seems obvious, but bubbles can be difficult to identify, and even if you do identify one, it could take a long time until you're proven right that it is a bubble. 

For a start, they are often driven by a combination of economic, financial and psychological factors that can be difficult to measure and even anticipate. 

The causes are also widely debated, as several factors generally lead to them and cause them to burst. If we look back at the sub-prime mortgages and housing markets in 2007-8, the collapse came due to a combination of homeowners having poor credit resulting in foreclosures, a lack of regulation which allowed financial institutions to take on too much risk, and complex products, like CDOs (collateralised debt obligations) being sold to investors who didn't understand them. And that's just some of the factors. 

However, if there's one thing bubbles have in common, it's that they are unsustainable in the long term. Plenty of traders and investors have been able to pick up on the signs in previous years, even if most people don't. 

There's a lot of money to be made when you correctly forecast one, but timing can be tricky. Just look at the examples from the famous book and film 'The Big Short'. For the traders involved, a lot of their holding time of their positions was spent suffering as the market continued to move against them and they needed to pay collateral. The stress and pressure can be too much to handle for many traders.

However, you can always combine trading approaches, limiting risk and not holding onto losing trades for long periods. Think of it like taking many small losses in anticipation of a bigger profit; much better for our sanity and our drawdowns.

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