What You Should Know About Asset Bubbles

With an asset bubble, nothing is ever as it seems. An asset bubble is simply defined as situation where the price of investment assets like stocks, gold or real estate, suddenly and dramatically rises over a short period of time.

Everybody wants to make more money. As such, in a case where an investor suddenly makes huge gains on his or her investment, seldom will the person consider it to be a challenge.

However, with an asset bubble, nothing is ever as it seems. An asset bubble is simply defined as situation where the price of investment assets like stocks, gold or real estate, suddenly and dramatically rises over a short period of time.

This rise is usually not supported by the value of the product, leading to an automatic overvaluation. What makes it slightly different from an overvaluation is the speed and irrationality of it and as a result of the unsustainability of it, soon enough the asset bursts and prices crash.

For this reason, it is important to know and understand the concept of asset bubbles as well as what causes one. There are two main causes:

The Primary Causes Of An Asset Bubble

High Demand/ Low Supply

While there are so many reasons why there could be a sudden increase in asset prices, the primary reason has to do with increased demand which is not supported by a proportional increase in supply.

In other words, it is a situation when the buyers' demand for an asset is much higher the available supply of that asset. For example, where many investors flock to one specific stock in the stock market probably as a result of new information or a form of speculation, there leads to an increased demand in the asset.

Beyond speculation, there are also situations where there is real scarcity of an asset – or at least, a perception that there aren’t enough of a specific asset to go around. This gap in supply also causes asset prices to rise beyond their real value.

With more people vying to purchase the limited shares of the company, the price increases in the free market thus spiking the value for existing owners of the asset or stock holders. By so doing, investors simple keep bidding up the price of the asset. Whilst this could spell short term gains for the investor, it is largely unsustainable as there is no real increase in value.

Low Interest Rates On Borrowing

Another interesting reason asset bubbles could occur is where people have too much money to spend on investments. An indicator of this is where the interest rates on borrowing for a certain period is so low, people have the opportunity to borrow money at cheap rates.

While this boosts economic activity and increases investment spending, the goal of these investors will be to make as much money as they can from their borrowed funds.

As such, more often than not, they opt for securities having higher risk and potentially higher gains. This ultimately drives price up and leads to an asset bubble.

It is important that every investor understands this so as not to move with the crowd, building castes in the air.

Written by Lawretta Egba.