What is the financial bubble and how does it affect investments?

Regarding economic issues, bubbles are situations that cause an increase in the prices of goods causing a loss in the balance of the financial market.

Bubbles can affect many markets and cause many financial problems and economic crises, however, there are options that are less likely to be affected by them, such as the real estate sector.

Knowing how bubbles are produced – and how they can affect your finances – will be key to preventing, and protecting your capital with accurate investments, such as commercial land.

In this article Blue World City will talk about financial bubbles and everything you need to know about them.

What is a financial bubble?

The financial bubble is an economic situation or phenomenon that consists of the disproportionate increase in the price of some product or asset, separating itself from its fair value. It is also known as an economic bubble, market bubble, or speculative bubble.

Depending on the sector in which the bubble occurs, it may have more specific names, for example, if it occurs in the real estate sector it is called a real estate bubble, or in the case of a technology company, it would be a technology bubble.

Where does the term bubble come from? It has its origins in the years 1929 in the financial context caused by the economic crisis in the South Seas.

Financial bubble characteristics

The main characteristic of an economic bubble is a prolonged and unchecked price rise in a good or asset. This situation occurs as a consequence of speculation – for this reason it is known as a speculative bubble – and it maintains this behavior until the euphoria ends.

In bubbles, a psychological factor intervenes in which people, driven by ambition, cause the value of assets – which are the object of speculation – to begin to rise without financial support.

After the analysis of several experts on the subject, it has been concluded that what the bubbles that have affected the economy in the past have in common is:

  • A product or asset becomes popular in an irrational way, causing unfamiliar people to invest.
  • It is perceived as an innovation which increases the sense of urgency to invest and obtain benefits.
  • On the other hand, a feeling persists in the environment that it is too good to be true, and in most cases, it is not.
  • It is a volatile investment, as its value can change very easily.
  • They are difficult to identify, that is, it is known that it is a bubble when it has already burst and the effects are suffered.

What are the causes of a financial bubble?

The bubbles are born from the markets themselves, derived from the shift in demand towards a certain asset. Some experts on the subject mention that a specific cause is not known, while other economists continue to deny the existence of these bubbles.

It is important to mention that bubbles do not only arise from speculation, they can also be due to trends and fads in the market, and go unnoticed until it is too late.

Bubbles can happen in any type of market in an unpredictable way. There are many theories around this phenomenon, trying to explain its origin and operation. Among these theories, the best known is the dumbest theory.

What is this theory about? It explains that the behavior of excessive price increases will not stop as long as there are consumers in the market (considered fools), who believe that in the future they will be able to sell and obtain a profit (based on predatory speculation).

The result of this is that said increase can continue until reaching absurd amounts for a good or product, which are far from its real value. This can continue until the last (dumbest) buyer can’t find another buyer to sell to and loses their investment.

Another popular theory is that of herding behavior. This mentions that investors are like a school of fish and follow a herd behavior, that is, they go where others are going without an organization or coordination.

The risk of this is that if the investment is not viable, people will continue to add, increasing its value to the point of making it unsustainable. This occurs due to the lack of initiative to investigate on their own instead of blindly following other investors as experts.

While gregarious behavior is not only present in the financial aspect, it has been seen that by nature, the human being tends to follow popularized fashions and behaviors, which change depending on the social context and the time.

However, some specific events favor the formation of bubbles —they do not always arise from speculation—, among which the following stand out:

  • A good or product that becomes popular for the belief that it provides great returns, which in the company of the lack of options and more profitable alternatives push the market towards these investments.
  • The blind trust that many people have in some financial experts, which can lead to a collective euphoria pushing the market in an unviable direction.
  • The opportunities for access to cheap credit, because the more resources available to invest, the greater the effect of the bubble.
  • Another very common cause is poor financial memory, that is, although there is knowledge of other bubbles and what their causes and evolution were – which would allow us to recognize them – it is very easy to ignore and make the same mistakes again.
  • The feeling of scarcity caused by the lack of response and slowness of the supplier. This causes an increase in the demand for said good, increasing prices disproportionately.

Phases of financial bubbles

As we have seen, the increase in the price of an asset is due to collective financial behavior —among other causes— where the company’s shares or products fictitiously increase in value.

This can be divided into two general phases:

  • First phase: It is known as the ascending phase. In this, the object of speculation is constantly revalued as a consequence of the excessive demand of investors, who seek to participate and obtain a “slice of the cake”, giving rise to a collective euphoria.
  • Second phase: It is called as descending phase. This occurs when investors withdraw or begin to sell assets, the consequence of which is excessive production for which there is no longer a market. The price of assets begins a spiral decline, falling below the real value.

To better understand the process of economic bubbles, here is how they develop:

1. Start of the bubble

It is also known as take-off of the bubble or take-of (in English). It consists of shifting demand towards a specific asset. As we have seen, it causes an over demand and a shortage of said good.

Due to a false sense of urgency and overvaluation of the asset, it initiates an increase in its prices, affecting interest rates and initiating an economic imbalance in the market to which it belongs.

At this stage, investors must investigate before carrying out any operation, being successful in their investments and preventing participating in a bubble will depend on the good financial decisions that are carried out.

2. Bubble boom

Driven by the collective euphoria, inexperienced investors put their reasoning aside, plunging into a flow that continues until it collapses.

In this stage, a purchase and resale are carried out with exaggerated prices of the assets, in order to obtain an immediate profit, which only causes the asset to continue to inflate its value.

Another characteristic of this stage is that in the hope that the acquired asset increases its value, these are acquired through credits or financing, which are not paid with the expectation that it will be paid only when its value increases.

This affects companies that stop receiving the full amount for their assets and investors, who by not increasing the value of their investment, remain in debt and even lose their money.

3. Bursting the bubble

The end of the bubble or falling phase is when you begin to suspect that it is a bubble. As the price continues to rise, so do buyers who decide not to buy such expensive assets and who begin to suspect that prices are inflated or overvalued.

This rapid decline leads to a depletion of the market, which begins a reduction in prices. This leads to widespread panic and – as the dumbest theory mentions – investors start selling until they reach the one, they can no longer do.

This is also known as financial depression, which can last from days to years. 

One of the main consequences of an economic bubble is the possibility of causing a stock market crash. Examples of this are the Crack of 1929, Black Monday of 1987 and the world stock market crash of 2008.

Historical examples of financial bubbles

Taking the foregoing as a reference, we will tell you about the examples of speculative bubbles that shook financial markets in various parts of the world, of which studies are carried out that are intended to allow us to recognize the bubbles from their inception and avoid market crashes.

1. Tulip crisis or tulipomania

The Dutch tulip mania was developed in the 1630s in the Netherlands, was a widespread speculative fever. The curious thing about this crisis is that the speculative object – now that it is analyzed – was the most curious, it was tulip bulbs.

What was the origin of this bubble? The bulbs in question were collectors’ items – they mutated into beautiful and unusual stripes of colors that gave rise to wonderful unique flowers – which caused inexperienced speculators to want to participate without prior knowledge, causing the prices of these bulbs to rise.

2. The great depression of 1929

This is one of the most studied economic crises and with the greatest repercussions worldwide. It took place in the United States at the end of the First World War.

The country experienced an increase in the value of some companies, the results were a disproportionate increase in the value of their shares, and an excess of confidence in the banks who granted loans to people who thought they could pay them.

The consequences of this crisis were worldwide, and its effects were felt for 7 years.

3. The housing bubble in Japan

This crisis took place in Japan in the 1980s after World War II. The country began its reconstruction by growing 10% per year, giving rise to a speculative bubble that triggered the value of real estate.

The recovery period after the bubble burst in 1989 was known as “the lost decade.”

If you want to make accurate real estate investments, we have prepared two articles that will help you accurately choose the ideal property for your venture or business: What is profitability and how to get it on your land? and benefits of buying land in a commercial area.

4. Other financial bubbles

Other crises that shook the world were:

  • The toxic mortgage crisis.
  • The dotcom bubbles.
  • The Mississippi Crisis.
  • The bubble of the south seas.

Investing in real estate protects your money

Now that you know what financial bubbles are and what their causes are, we can conclude that bubbles will continue to occur, therefore the best way to protect your capital is by investing in a safe and stable market such as real estate, especially, the lands.

As we have mentioned in other articles on our blog, commercial land has been shown to have higher returns, opportunities to earn passive income through leasing, and a retirement estate.

Mexico is a country that offers opportunities for everyone, therefore, if you are a foreigner, we recommend reading: Can a foreigner buy a property in Mexico? In this way you can acquire land in Cancun or real estate in Playa del Carmen to obtain higher returns without risk.

At BMF Inversions we have developments designed to meet the needs of your industry or company. We are backed by more than 25 years of real estate successes and market studies that guarantee the growth potential of our projects.