Bubble

What is a bubble?

A bubble occurs when the price of a traded asset grows beyond its true value. The price of the asset grows rapidly and masks the relative insecurity of the price, which eventually results in a sudden, unanticipated drop in value of the asset. Because of this, bubbles are often only identified after they’ve “burst,” causing financial distress for the asset’s owners. The crash of the housing market in the late 2000s was caused by the bursting of one such bubble.

Deeper definition

Bubbles develop within a market or industry, such as the stock market or the housing market. Bubbles grow until investors realize the asset’s prices are far higher than what is justified, causing a sell-off and a decline of the asset’s price that could result in a market crash.

Speculative bubbles occur when spikes in an asset’s value are caused by inflated expectations of future growth, price appreciation, or such social factors as increased demand for a material good. There have also been bubbles in commodities, such as oil or foodstuffs, which happen when demand for the commodity increases at an unusually higher rate. This boom period is often followed by a bust period, when demand has cooled but added production capacity contributes to a drop in prices for the commodity.

Using Bankrate’s investment calculators, you can determine the best way to grow your savings.

Bubble example

The rapid growth of the tech industry of the late 1990s and early 2000s is one of the more prominent recent examples of a bubble. As more and more people began using the internet, investors paid higher and higher prices for stock in so-called dot-com companies, constituting a boom period. Many of those companies failed to turn a profit, and their stocks quickly depleted in value, leaving speculators out billions of dollars.

Similarly, in the mid-2000s, banks in the U.S. began issuing what are called subprime loans, which are risky for lenders because their borrowers are struggling with financial difficulty, including bad credit and unemployment. These loans led to a buying frenzy that drove up housing prices by as much as 100 percent.

It soon emerged that borrowers were unable to keep up with their payments. At the peak of the bubble, more than 1 percent of all homes were in foreclosure. Housing prices declined more than 40 percent in some parts of the country, destroying the value of the loans and creating a credit crisis that helped cause the housing market bubble to burst. By 2007, the country was in a severe recession.

Other Investing Terms

Prudent investor rule

Prudent investor rule is a term every investor should understand. Bankrate explains it.

Fiduciary rule

The fiduciary rule describes what a financial advisor can do with your money.

Repurchase agreement (repo loan)

A repurchase agreement is a short-term loan to raise quick cash. Bankrate explains.

Derivative

Derivative

More From Bankrate