What Causes a Stock Market Bubble and Crashes? | Motilal Oswal
What Causes a Stock Market Bubble and Crashes? | Motilal Oswal

Understanding stock market bubbles and crashes

A stock market bubble, also known as an asset bubble or speculative bubble, occurs when the price of a stock or asset rises exponentially over time, much above its intrinsic value. As the bubble “pops,” prices eventually hit a ceiling and then plummet dramatically. Aside from equities, bubbles can arise in a variety of assets, including real estate, collectibles, commodities trading, and cryptocurrency trading.

What Causes a Stock Market Bubble?

  • Pure speculation fuels a stock market bubble. When the price of an asset begins to rise at a rate that exceeds its fundamental value, a bubble begins to form. Then investors are willing to pay increasingly higher prices for a security or other asset, above and above what is projected based on factors such as demand, earnings, revenue, or growth potential.
  • The term "irrational exuberance" characterises the collective enthusiasm among online stock traders and investors that supports quickly rising prices that outpace underlying fundamentals. Whether you call it herd mentality, herd prejudice, the bandwagon effect, or FOMO, there is a self-reinforcing loop in which individuals want to acquire an asset because its price is rising, which drives the price further higher and makes even more people want to buy it.
  • It's crucial to remember that not all price accelerations are bubbles. It's common for asset prices to rise sharply after a recession or bear market, for example. While hope and speculation may also fuel the rebound—namely, that the worst of the market downturn or an economic slowdown has passed—the essential difference is that these price gains can be justified by fundamentals in the end.

The Different Stages of a Stock Market Bubble

Stock market bubbles usually go through the same five stages:

  • Displacement

A large event, or a series of adjustments, influences how investors think about markets in the early stages of a bubble. This paradigm shift could be caused by a significant event or invention that prompts people to modify their expectations regarding the asset in issue, with positive intentions.

  • Boom

Price increases during the displacement stage, but things really get up during the second stage of a bubble. As word of the asset's gains spreads, the boom period attracts speculators, who assist drive the price of the asset higher.

  • Euphoria

As the asset's price soars, the fervour grows even stronger. People are more motivated by excitement than sensible justification for the massive price increase during the peak bliss stage. And, because fresh investors are eager to join, there's a feeling that someone will always be willing to pay more for the asset.

This can make it seem as if there's no way you'll lose money regardless of when you invest. During periods of enthusiasm, investors have thrown caution to the wind in search of what appears to be a too-good-to-be-true opportunity to become wealthy rapidly.

  • Taking a Profit

Inevitably, the price increase proves to be too good to be true. Booms are followed by collapses, and as the bubble enters the profit-taking stage, some investors begin selling to lock in gains. The stock market bubble has burst, and those who understand the warning signs will profit sooner rather than later.

  • Panic

While some late-comers to the game may have waited out in the past, hoping that an asset's price would rise again, by the time the bubble reaches its panic stage, this is no longer a viable option. Instead, the zeal to acquire an item has given way to a panic to sell it. The price drop wipes out gains rapidly and stimulates additional panic-driven selling.

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