UK Accounting Glossary
In markets, a bubble is an extended period of extreme overvaluation. Bubbles occur in stock markets, real estate, commodities and precious metals. There have even been bubbles in the flower market, the most famous example being the Dutch Tulip Mania of the seventeenth century. Bubbles are formed when excessive speculation enters a market. Instead of viewing the intrinsic value of an asset, speculators in a bubble market instead focus on the resale value of the asset. This is sometimes referred to as the greater fool theory of investing. In a bubble, it doesn’t seem to matter that a price is irrationally high – it only matters that it can be sold for an even more irrational price at a later date. Bubbles often end with steep declines, where most of the speculative gains are quickly wiped out.
All bubbles eventually burst – whether it be those found in soap powder, the U.K. housing market or those associated with the stock market. Unreasoned and excessive buying of shares in a company that is financially weak, and/or becomes overvalued, will increase the market price of its shares to unsustainable levels.
The herd instinct among brokers and investors in the stock market leads share (and other) markets to rise – far more than people expect – and then fall – far more than those same people expect!
The ‘rising’ phase of the upturn tends to become an increasing ‘buying frenzy’. Investors tend to increasingly believe if they don’t ‘buy now’ they’ll miss out and be forced to pay even higher prices later.
Older brokers ought to know better if they’ve been around for previous crashes, but even they invariably get caught up in wild exuberance. You know something is becoming ‘a bubble’ when
people start buying anything (good and bad assets)
comparisons with previous market crashes are dismissed with the justification ‘the economic conditions are different this time’!
A bubble in the U.K. housing market burst in the late 1980s, taking prices down by 30% or more in some areas over the next six or so years.
The most famous stock market bubble was the South Sea Bubble of 1720. Stocks in the South Sea Company soared spectacularly, only to crash equally spectacularly.
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This glossary post was last updated: 4th February 2020.