As evident from the results of the Brexit poll and the US elections in 2016, human beings exhibit a highly irrational behavior. One of the best examples of such anomalous behavior is the financial bubble, which is created when people start trading in an asset too much, pushing up its prices way beyond what it is actually worth. This article covers a brief detail about how a flower became more expensive than a house in Amsterdam, what causes a financial bubble and the life cycle of a bubble.

How a flower became more expensive than a house?

Tulipmania, which occurred in the 17th century, is believed to be the world's first ever financial bubble. Within a period of a few months, Tulip bulb prices in the Netherlands skyrocketed to insane heights before nose-diving to worthlessness, leaving several investors bankrupt. At one point, a single Tulip bulb was valued at around 6,000 guilders, roughly the same as the cost of a luxurious mansion in Amsterdam! This 3-minute video perfectly elucidates how it all happened.

What causes a financial bubble?

A bubble gets created when people start trading in an asset at prices that highly exceed its actual (or intrinsic) value. As this trading continues, the price of the asset keeps getting further inflated making it seem highly attractive to potential investors. As more and more investors join the bandwagon, the price starts increasing at an unprecedented rate.

Stage 1: Displacement

All bubbles are formed when something new is perceived to be happening. It might be a new discovery, a breakthrough technology or something else which might have the potential of having immense value in the future. In this stage, smart investors notice that something big is about to happen and start investing in it. Having the first-mover advantage, these smart investors get to ride the price curve once the asset prices start moving upwards. In the 1990s, people had started investing in the internet, in the late 2000s, the newly tweaked Collateralized Debt Obligations (CDO) consisting of subprime loans were selling like hotcakes. In the above case, it was tulip bulbs.

Stage 2: Boom

This is the rapid growth phase. Once the bubble formation picks up, people develop a convincing narrative to justify why the asset is a good investment. This narrative becomes self-reinforcing as more and more people start talking about it. After acquiring critical mass, this narrative keeps gaining momentum and spreads like wildfire. This results in a huge number of people believing in the high future value of the asset. 

Stage 3: Euphoria

In this phase, the asset reaches its peak value. As prices are rising at a very high rate, everyone finds the asset to be a phenomenal investment. Even those who were sitting on the fence are convinced that it is the right time to invest. The number of investors keeps snowballing further pushing up the price of the asset. As more and more people are ready to invest, the asset price reaches new highs shattering all previous records.

Stage 4: Crisis

For each bubble, there is a tipping point when people start realizing that the asset is hugely overpriced. This usually starts with people within the industry who are working very closely with the asset. These industry insiders then start selling off their investments. At some point in time, the news about this insider selling leaks out to the general public. As a consequence, panic selling starts and all investors are trying to get rid of the asset by dumping it back in the market. 

Stage 5: Revulsion

As the panic spreads, the asset gets demonized and looked upon as an evil investment by everyone in the investment world. Even journals that were singing the asset's praises a few months back start writing negative things about it. As shown in the graph below, the asset prices go into a free fall dropping even below its actual intrinsic value. Finally, with time things settle down and the value of the asset is restored to its mean. 

Anatomy of a Typical Bubble (Source: Jean-Paul Rodrique)

Are we going to have a bubble soon?

In June 2018, it will be 10 years since the last major financial meltdown. Based on the past few decades, the usual frequency of occurrence is once in a decade. Fortunately or unfortunately, this decade hasn't had a major bubble yet! Should we expect one soon? If only we could predict human behavior. However, we should always be prepared for one.

To end it on a lighter note, here is a cartoon that very aptly depicts human behavior...