Anatomy of a Bubble


The above chart was formulated by Dr. Jean-Paul Rodrigue in 2006, in the middle of the developing housing bubble. It illustrates the general pattern that most market bubbles tend to follow.

Early on, a small number of money managers and other sophisticated investors begin speculating that a given asset may be undervalued and establish small investments in the hopes of future gains. As these initial investments start to pay off, other managers begin to notice their success and follow suit, slowly ramping up prices. There may be one or more temporary sell-offs as early investors decide that their speculation has paid off and pull out of assets that they now perceive as overvalued.

Sometimes, this is as far as a price fluctuation will go. When a rising price starts to attract media attention, however, it creates the potential for a true bubble. At this point the price may already be significantly over asset value and the original “smart money” investors’ reasons for buying no longer apply. But as the general public becomes more aware of the success stories that the rising prices have created, more and more people buy in. This drives the price up even further, reinforcing the public perception that an easy money-making proposition has been discovered.

As the bubble nears its peak, wise investors quietly pull out as it becomes clear that the price is unjustified and unsustainable. Latecomers with little understanding of their holdings invent new explanations to rationalize the extreme overvaluations the bubble has created. They believe the old rules no longer apply and the inflated price is the new “normal.”

At some point, reality sets in and triggers a cascade in price. The bubble begins to deflate, although bullish investors may try to deny that this is happening. They see the initial decline as a buying opportunity, creating short-lived recoveries before the bubble goes into its final plunge. Often, the aftermath of the bubble leaves the asset so despised it becomes badly undervalued, creating buying opportunities for savvy investors—which may eventually generate the start of the next bubble, many years down the line.

We already know the lesson here: avoid the stampede. When we hear everyone else is buying something, it’s tempting to join in. But even when it seems like the price just keeps going up and up, we know what’s eventually around the corner.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Investing involves risk including loss of principal. No strategy assures success or protects against loss.