Stock market bubbles don't grow out of thin air. They have a solid basis in reality, but reality as distorted by a misconception. - George Soros
A bubble is the perfect symbolism for an idea or phenomenon that is ephemeral in nature, as every bubble, however beautiful, must eventually burst. Stock markets are some of the most sophisticated gambling arenas that decide the fortunes of millions, who invest their life savings. Before we talk about bubbles in the stock market, let me provide the briefest of introductions to the working of stock markets, for those of you, who are new to the idea of stock trading.
A stock is a quantum of ownership or 'Equity' in a business, sold by the holding company through an initial public offering (IPO), which is consequently traded on a stock market, via qualified traders. An investor can make a profit in the stock market, by buying shares at low value and selling them, as their value rises.
Prices of stocks are largely driven by the performance and potential of the company it represents, demand-supply ratio for the stock and investor speculation. As demand for a stock rises, its price rises. On the other hand, as the demand for a stock lessens, its price falls. Ergo, one could say that investor sentiment about the future performance potential of a stock and speculation are large driving forces that influence the stock prices.
What is a Stock Market Bubble?
A bubble is a sudden rise in the prices of stocks belonging to a particular sector (buoyed by investor belief in the future performance potential), that makes them attain values which are far beyond their intrinsic price; followed by a gradual or sudden decline (burst) in their prices, as investors offload their holding in them.
It is a case of unwarranted optimism in a sector, that is followed by extreme pessimism by the investors that results into a catastrophic drop in process. A market bubble is one of the many types of 'Economic Bubbles', that can drive financial sectors to go boom and bust.
In most of the historic bubble bursts or 'Price Free Falls' that have occurred, gullible investors, who were too optimistic about the sector have inevitably lost a substantial amount of their fortunes as prices went into free fall. One of the historic examples of market bubbles is the 'Dot Com Bubble' burst that drove the new Internet company stocks to unrealistically high values in the 90s, before finally pushing them into free fall, that saw many of them being wiped out of business.
What Inflates the Bubble?
Many factors come together to create a bubble, but one of the prime ingredients is 'Unrealistic Expectations'. They typically occur in emerging industrial sectors that are touted to be the 'Next big things', as the Internet companies were. Due to the novelty of these technologies, investors don't have the benefit of hindsight to predict the performance of companies in these sectors.
Excess liquidity in the market is also one of the factors which drives bubbles to grow. There is no single reason that has been identified by researchers to be the root cause of a bubble. However, one of the prime reasons can be identified to be 'Speculation and belief overriding sound reason'.
It's essential that every investor knows about market bubbles, which are monumental examples of folly, that can ruin lives. The best way of insulating yourself from them, is to stop basing your investment decisions on speculation. Study the financial fundamentals and performance of the company to determine the intrinsic value of the stock.
The stock market, driven by the human psyche is bound to swing between extreme optimism to extreme pessimism, driven by fear. As the master investor Benjamin Graham has said in one of his books, 'The intelligent investor is a realist who sells to optimists and buys from pessimists'. Ergo, being a realist is the most important aspect of being a stock investor and saving yourself from bursting bubbles.