Fearing they might miss out on potential growth, investors often continue buying an asset and pushing its price further than it should reasonably grow; in this way, bubbles become almost self-fulfilling.
That said, there are some hallmarks that almost every bubble features, including:. Not necessarily, because investors view these low-earning, high-unemployment conditions as temporary. But accurately predicting the rise and fall of bubbles is almost impossible, and we should always be prepared for the unexpected in the world of economics.
Skip to primary navigation Skip to main content Skip to primary sidebar Skip to secondary sidebar A Publishing Platform for Student Pieces With the stock market fluctuating wildly despite signs of poor economic conditions including record unemployment , some economists are speculating that we may be in an economic bubble. What Is an Economic Bubble? That said, there are some hallmarks that almost every bubble features, including: Excessive greed or optimism.
Overall, people tend to be excessively greedy or optimistic. Prices also start to increase beyond their hypothetical value. Number one, that President Trump will be able to lower corporate tax rates. Number two is the belief that there will be a big infrastructure spending program. And the third expectation that I believe is driving current stock market valuations is that companies expect to be able to repatriate capital back from overseas.
Bringing that capital back could result in higher investment activity, perhaps increasing economic activity, and presumably that could translate into higher earnings.
One of the more substantial examples, perhaps, is the rise of passive investing. Dispersion across stocks is dropping, and I think one of the primary drivers of that is the rise of passive investing. The fundamental basis upon which passive investing has been justified is a valid price mechanism. A valid price mechanism is usually the output of active buyers and sellers negotiating what a stock should be worth. If a stock is overvalued, someone will sell it.
There is this tendency towards an accurate—insofar as that has any meaning—price. With passive investing, price is based on flows. All stocks in an index move up with inflows. All stocks in the index will move down with outflows. The quality of the individual company matters less. Buying and selling pressure to determine the price of an individual security is being lost as passive investing gains share.
That is very concerning to me, because it takes away the basis upon which passive investing is justified. There are definitely undervalued companies outside the index that are not being valued properly. There are likely companies that are overvalued within the index that have been the beneficiary of inflows.
It creates confusing dynamics and lots of distortions to underlying prices. That leads to misallocated capital. And that creates bubbles. Your Money. Personal Finance. Your Practice. Popular Courses. Economics Behavioral Economics.
What Is the Bubble Theory? Key Takeaways The bubble theory is any economic or financial theory that recognizes the existence of or seeks to explain bubbles in market prices. Prices of any asset can get much higher than apparent values warrant from time to time, but how long the bubble will last may be difficult to predict or even detect.
Various economic theories have been advanced to explain the causes and mechanisms behind bubbles or to better predict them. Bubbles can present enormous opportunities for profit but also pose major risks for the unwary investor. Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear.
Investopedia does not include all offers available in the marketplace. Irrational exuberance refers to investor enthusiasm that drives asset prices higher than those assets' fundamentals justify. Inefficient Market Definition An inefficient market, according to economic theory, is one where prices do not reflect all information available.
Market Psychology Market psychology refers to the prevailing sentiment of investors at any given time and can impact market direction regardless of the fundamentals. Herd Instinct Herd instinct in finance is the phenomenon where investors follow what they perceive other investors are doing rather than their own analysis. Value Investing: How to Invest Like Warren Buffett Value investors like Warren Buffett select undervalued stocks trading at less than their intrinsic book value that have long-term potential.
Partner Links. Related Articles. Markets 5 Stages of A Bubble. Stocks Modern Portfolio Theory Vs. Behavioral Finance.
Investopedia is part of the Dotdash publishing family.
0コメント