Investors who join the market during a bubble and are not discouraged by the market volatility may end up making a lot of money in the stock market just because they chose to ride the bubble. Going back to the story of the tulip, the market dealers were the first to sense danger. This was because, in that market, only the dealer had vital information regarding the buyers and sellers of the tulips. In the case of tulips in Holland during the 1600s, the country was experiencing robust economic expansion as a result of a surge in international trade. Since tulips were rare, took a long time to develop, and were viewed as a symbol of luxury, they were the ideal candidates for inciting a frenzy among the Dutch. But — and it’s a big but — there are several tell-a-tale signs that sophisticated investors use to determine when a market is approaching nosebleed territory.

The South Sea Company was founded in 1711 to capitalize on a commercial monopoly with the Spanish territories in South America. Thousands of excited investors flocked to the stock, which offered a guaranteed return of 6% after the company’s directors promised huge returns on investment. During a bubble, some investors take their time before they allow themselves to be swept by the tide — especially those who are more risk-averse. Although they have to make a full prediction, experts are able to tell when there is an imminent danger. For instance, there have been many predictions in the last few months that the current stock market might be approaching or already in a bubble.

A bubble burst

But when the stock market began to rise again, interest rates also started to rise. For homeowners with ARMs, their mortgages started to refinance at higher rates. The value of these homes took a nosedive, which triggered a sell-off in mortgage-backed securities (MBSs). This eventually led to an environment that resulted in millions of dollars in mortgage defaults. To avoid the inherent risk of participating in a bubble that eventually bursts, it’s important to carefully consider your reasons for investing before you do so. The result was an increased demand for stocks of tech startups, which pushed the value of their shares to higher levels.

What Is a Stock Market Bubble?

• Eventually, the stock prices vastly outweigh the underlying value of the companies whose stocks they represent.
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• The disadvantages of these alternatives are that buying put options can be expensive, and stop-loss orders might be executed during only a modest market pullback rather than a bubble popping entirely.
• This can make it feel like there’s no risk you’ll lose money no matter when you buy in.
• Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com.

Even so, it’s possible to recognize signs of a bubble when an asset’s price rises above and beyond its fundamental value. By identifying behavior that aligns with the early stages of a bubble, it floor trader’s method may be possible to recognize an economic bubble while it’s happening, though it’s impossible to know if and when prices will eventually fall. While some late-to-the-game speculators may have held out previously—in hopes that an asset’s price might go back up—by the time the bubble reaches its panic stage, that’s no longer tenable. Instead, the fervor to buy an asset has been replaced by a panic to sell.

Importance of Understanding Stock Market Bubbles