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Created on 31.05.2018

What is a speculative bubble?

Have you ever heard about the tulip bulb bubble in the Netherlands during the 17th century? Or about the baseball card bubble in the USA during the 1980s? You haven’t? But you’ll surely be familiar with the subprime crisis or the dot-com bubble. Whether tulips, collector cards, real estate or tech shares – all of these events spread across several centuries have one thing in common: they’re so-called speculative bubbles.

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The tulip bulb bubble is considered the first speculative bubble in history. The tulip was still exotic and uncommon at the time, and it quickly developed into a status symbol, attracting the interest of merchants who speculated for increasing prices. After an explosive price hike, the tulip trade came to a standstill. Increasing numbers of investors had bet on tulips and triggered a true speculation mania, which led to a grossly overvalued market and, as a result, to a collapse in the market. While the flower bulb example may sound absurd, it’s an example of a cycle which can often be found in the investment world: speculative bubbles develop and burst in the same way (or at least in similar ways) over and over again.

How do speculative bubbles develop?

In simple terms, speculative bubbles develop whenever a supposedly good opportunity to make a fast buck occurs, and a large number of people can take advantage of this with relative ease. In these cases, many people expect the value of a certain good or asset to rise. And who wouldn’t like to benefit from that? But it’s often not that easy. As the demand for such a good or asset rises steadily, market prices will initially also rise. But it will very soon become clear that there’s been an overvaluation, meaning that the prices paid are far too high. This is what is known as a speculative bubble. As investors realize this, they will try to sell the good or asset as quickly as possible. But of course there will hardly be any buyers left by that time, leading to rapid price drops, sometimes even towards zero. The bubble has burst!

Why do speculative bubbles develop?

The exact causes of speculative bubbles aren’t entirely clear and have been subject to controversy. Possible reasons for the development of such bubbles include:

  • Investors don’t act rationally but imitate the behaviour of others. This herd mentality leads to people investing because they hope for a fast buck without understanding the good or asset.
  • In behavioural economics, this principle is called “bounded rationality”. This means that people don’t always make rational decisions, because their knowledge is limited and the information they have is incomplete.
  • The “greater fool” hypothesis assumes that investors are confident there will always be somebody willing to pay an even higher price than themselves. They therefore expect to find an even “greater fool” to whom they can sell their good or asset at a profit.

And of course investors always hope that “everything will be different this time”. But even if bubbles aren’t initially easy to spot: be careful when there’s a seemingly endless return potential and always keep yourself thoroughly informed. If an investment seems “too good to be true”, that’s probably the case.

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