A speculative bubble is a period of extreme asset prices that are detached from economic realities. Major speculative bubbles are a common occurrence in the history of modern markets. They typically involve an exciting new type of asset. Historically, speculative bubbles have involved things like tulips, canals, railways, real estate, metals and technology. Speculative bubbles often involve several waves of investors:
OptimismCalculating the net present value of the future cash flows for an investment involves predictions of the future that are inherently uncertain. It is possible for an overly optimistic view of the future to result in an extremely inflated estimate. Speculation is the purchase of an asset without sufficient understanding of its value and risks. For example, purchasing an asset based on technical analysis with no understanding of its fundamental value.
ExtrapolationThe speculative process of looking at past results and expecting them to continue. For example, a stock goes up 100% a year for three years in a row and people begin to expect such returns to continue.Speculative bubbles are surrounded in media and word of mouth stories about all the people who have become wealthy by purchasing the asset. This triggers a fear of missing out whereby people rush to purchase out of a sense of social competition.
Greater FoolInvestors who fully comprehend that an asset is significantly overvalued may purchase it anyway in an attempt to benefit from the waves of naive speculators buying it. Such investors understand that a crash in prices is coming but feel they can time it.
NotesSpeculative bubbles typically cause economic inefficiencies. As they grow they divert economic resources towards unproductive pursuits. They can also price the real users of assets out of the market. For example, a real estate bubble that leads to over-construction and a city filled with empty homes that are simply flipped over and over by investors while residents of the city find homes less and less affordable.---When speculative bubbles burst they can cause financial instability and may require the government to spend or create money to stabilize the system. Bursting bubbles may trigger a recession as they can damage the public's appetite for productive risk taking.
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