Stock markets: Protect your wealth from market bubbles

Amateur retail investors should learn more about market bubbles before investing. Excessive demand for a particular type of asset should be a red flag for investors

Stock markets: Protect your wealth from market bubbles
Now, what happens to rose prices if suddenly demand for it stops? Prices will tumble down and will probably drop close to zero.

By Parthajit Kayal

Would you ever pay Rs 1 lakh to buy one red rose? Absolutely not, because there is no fundamental use of this rose that justifies such a price. What if somebody is willing to buy it from you for Rs 2 lakh? Now, probably yes. But why would a person pay so much? Why not, if he/she is able to sell it for even much higher prices.

Now, what happens to rose prices if suddenly demand for it stops? Prices will tumble down and will probably drop close to zero. The same happened in the 17th century when Dutch investors purchased tulips, pushing their prices to unparalleled highs. The average price of a single tulip flower had  surpassed the cost of purchasing some houses at the time before it eventually collapsed. This is known as Tulipmania. It reflects the cycle of a bubble. In the  history of financial markets, many such bubbles are observed. For example, Japan’s asset bubble in the 1980s, the US tech bubble in the 1990s, the housing bubble in the2000s, etc.

Why do bubbles get formed?
Bubbles can be due to social, economic, and financial phenomena. It is caused by people’s desire for the experience of being part of something exciting, new, and trendy. This is supported by the availability of cheap money (excess liquidity, low-interest rates) and overall healthy economic conditions. Originally these bubbles start with some true fundamentals but eventually get over-extended and taken too far beyond a reasonable value. When valuation gets overstretched, investors start doubting the future prospect of the asset and start selling it. That is when the bubble starts bursting.

Sectoral bubble vs market bubble
When prices of particular or similar assets exceed their fundamental value by a large margin while other types of assets trade at a reasonable valuation, then it is a sectoral bubble. For example, crypto-bubble, commodity bubbles, etc. Similar observations can be made in a particular sector or a few sectors in the stock market at a time. Sectoral bubbles are more common. However, when the overall financial assets reach an inflated price (much higher than intrinsic worth) then it could be a sign of a market bubble. Market bubbles are more dangerous as all financial assets see massive sell-offs when the bubble bursts and investors lose money in all possible ways.

How to identify a possible bubble
Bubbles start forming when prices of a particular asset or assets exceed their long-term mean value without any significant fundamental changes in the underlying assets. If the prices exceed the historical highest value, then the bubble could be in its’ mature stage and ready to burst. However, investor’s euphoria could take the prices further up and make the bubble bigger when supported by high liquidity, favourable economic conditions, and excessive optimism.

How it impacts investor wealth
For any asset, prices should be supported by its fundamentals. Excessive rise in prices is likely to see a pullback when investors’ optimism reduces or economic conditions become tougher. When the bubble bursts, asset prices fall very sharply and suddenly. It creates a panic in financial markets. Everybody tries to come out of their long position and that causes the prices to fall further. Investors see a sudden and significant drop in their investment value. As financial markets are interconnected, a bubble in one asset class causes significant wealth destruction in other asset classes also. A bubble-burst could have a global impact as witnessed during the 2008 sub-prime crisis.

Amateur retail investors should learn more about financial markets’ bubbles before investing. They should be very cautious while investing in an asset with a continuous rise in prices. Excessive demand for a particular type of assets should be considered as a red flag. It is more important to protect existing wealth. Chasing high returns is more likely to destroy investors’ wealth.

The writer is assistant professor, Madras School of Economics

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First published on: 21-12-2021 at 01:30 IST