7 Key Reasons Why Bubbles Form

The term bubble has been in popular usage in the past few years. We’ve seen the Chinese stock index double and triple only to crash a spectacular 70% from its peak. We’ve seen oil prices make fresh highs daily despite a looming recession. We’ve also seen lots of hype about “Chinese and Indian growth” that was supposed to push commodity prices from copper to soybeans indefinitely higher (those voices have become suspiciously mute lately).

I won’t get into the technical details about what constitutes a bubble in this article. Instead, I’ll try explore some of the reasons why bubbles exist and have persisted among the history of markets.

1. Fundamentals
Most bubbles are based on some sliver of truth. Commodities were in a bull market from 2002/3 to 2008 for a reason. The USD did start losing ground against the Euro in 2002. Demand for commodities did increase rapidly before 2008. In short, all of these factors worked together to pave the way for a bull market in commodities.

If you think about it, even subprime loans were supposed to be profitable before money flooded the niche and turned it into a trillion dollar market.

2. Social Proof
Warren Buffett thinks social proof is a very powerful factor. “Everyone’s doing it, you have social proof, you look like an idiot if you don’t do it and the house gets more expensive next year.” Social proof is tremendously powerful and the intense peer pressure may make more people join the fray, further fueling the mania.

3. The Tipping Point
On page 196-197 of “The Tipping Point”, the author describes his idea of the “diffusion model”. “Then came the big bulge of farmers in 1936,1937 and 1938, the Early Majority and the Late Majority, the deliberate and the skeptical mass, who would never try anything until the most respected of farmers had tried it first.”

In everyday life, we may be skeptical about new things, but may be persuaded to try it after hearing positive feedback from neighbours or friends. This happens in the stock market too, which, replicated on a massive scale, leads to a bubble. This also ties together with social proof.

4. Sentiment
Due to need for social proof, it usually takes time for sentiment to build. But once convinced, public sentiment can take a surprisingly long time to abate. That is why Keynes famously noted how “markets can stay irrational longer than you can stay solvent”

It took decades for a new generation of risk-lovers to pop up from the ashes of the Great Depression, and it may take decades before we see bubbles on such a massive scale as we have in the past several years.

5. Analysts/Cheerleaders
These are also important players. It is very soothing and reassuring to be making the same investments recommended by “experts”. While many financial experts do great work, a considerable number get caught up in the optimism in a bull market (who doesn’t?), drawing many innocent investors into the markets.

For example, in early 2008 the famed experts at the World Economic Forum were debating about “decoupling”, namely the theory that Asian and other emerging markets would continue to grow even if growth in the US slows. We all know how that worked out.

6. Corrections
A correction is a slight retracement in a bull market, usually ranging around 10% and lasts for several weeks up to several months. Corrections are important to a bubble.

When a bubble meets with certain resistance, investor’s expectations and emotions may be slightly dampened, but if prices overcome the resistance and continue rising, it reassures investors that the “trend is still up”, which in turn fuels the bubble further. So paradoxically, corrections actually promote the further enlargement of a bubble.

7. Human Nature
As Buffett once said, “The human animal doesn’t get smarter about fear or greed.” Perhaps these are genetic traits, or maybe they are animal instincts inherited from our early ancestors that were hunted in forests. In any case, it does not appear that we are aware or can stop the periodic outbursts of greed and fear in the forseeable future.

Then again, who wants to live in a perfect world anyway. Best to educate ourselves about them and attempt to improve our investing. And to do that, you might consider reading the other excellent material provided on this site ;).

This was a guest post by StockTradingToGo Community member Allen. Other recent posts from this author:

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