In 1636, someone in Holland paid the modern equivalent of $500,000 for a tulip.
A single tulip.
Was it a special tulip, signed by da Vinci and Donatello?
Nope. In fact, there were millions just like it dotting the Dutch countryside – that’s just how valuable tulips became during the first documented economic bubble: Dutch Tulip Mania.
An economic bubble forms when the price of an asset gets wildly out of control, held up by speculation only. $500,000 for a tulip sounds nuts – unless you’re convinced it’ll be worth $600,000 tomorrow, which the Dutch were at the time.
Most economic bubbles are more subtle, which is why they’re so dangerous. If you’re not careful, you can accidentally invest in a bubble and lose tons of money.
What is an economic bubble?
In simple terms, an economic bubble is when the price of an asset gets rapidly and artificially inflated past its fundamental value due to investor demand.
So, in even simpler terms:
Price >>> Value = Potential Bubble
Assets that have experienced bubbles include stocks (entire sectors or just one stock), real estate, and crypto.
Even consumer goods like cars and Pokemon Cards can bubble in value!
Why should you care about economic bubbles?
If you have financial and investing goals, you need to know about economic bubbles in the same way surfers need to know about riptides.
If you’re not cautious, they can suck you under.
The reason economic bubbles are called bubbles is because they easily and inevitably burst. And when they burst, they can cost amateur investors like you and me thousands – sometimes even millions – of dollars.
Conversely, learning to spot bubbles can save you that amount of money, too.
If you can detect when a bubble is about to pop, you can swoop in when prices are low and save $10,000+ on houses, cars, and other assets that have plummeted back to their non-inflated values.
How do economic bubbles form?
The price of an asset doesn’t just explode overnight for no reason – so where do these economic bubbles come from?
Economic bubbles tend to form in five stages, with names seemingly borrowed from an EDM setlist:
To help illustrate the five stages, I’m going to weave in one of history’s wildest economic bubbles as an example.
Coincidentally, it also sounds like it belongs on an EDM festival poster: the Dutch Tulip Mania.
The displacement stage, also known as the excitement stage, is when a small first wave of investors notices the opportunity and invests in it. They’re excited, and they’re trying to get their friends and colleagues excited about it, too.
A perfect, cut-and-dry example of the displacement stage is how housing bubbles start: the Fed lowers interest rates on mortgages to below 3%, and investors and aspiring homeowners alike get “excited” and start buying.
Sometimes, the displacement stage can be sparked by a single investor’s “eureka” moment. This is exactly what happened in 2019, when a single video posted to Reddit sparked the displacement stage for the infamous GameStop investing craze of winter 2020-2021.
400 years before GameStop, something remarkably similar happened in Renaissance-era Holland. The roots of the Dutch Tulip Frenzy were planted, quite literally, when a Dutch botanist brought tulips back from Constantinople. His neighbor stole some of his tulips; sold them as an exotic, never-before-seen plant; and made a huge profit.
Tulips were the Bitcoin of the Dutch Golden Age – almost nobody knew about them at first, but those who did, thought:
“Holy moly – this is going to make me rich.”
That’s pretty much the defining phrase of the displacement stage.
Prices also remain pretty steady during the displacement stage. There aren’t enough buyers to drive prices skyward yet. Rather, the first wave of investors are quietly scooping up available inventory while they whisper, giggle, and clink champagne flutes.
Then, the media notices.
The boom stage occurs when the greater population learns about the opportunity and a second, larger wave of investors starts to pour money into it.
Booms typically begin the moment the mainstream media picks up on the story. To spot a developing bubble, just look for the words “frenzy” and “mania” in your Google News Feed:
As a result of these headlines, investors scramble to remember their Robinhood password…and prices start to rise.
If asset values were like a roller coaster, the boom stage is when they start to go tick tick tick tick tick up the first big hill.
Look at this graph of GameStop share prices over time, and see if you can spot when the letters “GME” started making headlines at CNN and Fox News:
Yep, you can see the roller coaster going tick tick tick tick tick right at the end of January.
Prices begin soaring during the boom stage, but even still, not everyone is on board just yet. Rather, booms typically attract investors who already have their finger on the trigger, so to speak. That might include:
- Institutional investors.
- People who were waiting for the right time to buy a house.
- Retail traders who already have a Robinhood/Webull account.
In short, people who were ready.
The boom stage gives me the perfect opportunity to highlight one of the biggest early warning signs of an economic bubble:
During regular market conditions, prices of an asset tend to remain steady. If demand rises or the stock performs well, prices will increase linearly.
But in an economic bubble, prices rise exponentially.
To illustrate, the Vanguard 500 Index Fund ETF (VOO) is in high demand, but it’s not in an economic bubble. That’s why it looks like this:
Whereas AMC went like this. You can spot the boom stage in early June:
It’s hard to say exactly how and when the boom started during Dutch Tulip Mania, but evidence suggests it came from several developments:
- The increased mention of tulips in Dutch newspapers.
- The sudden rise in tulip-related employment (farmers, armed guards).
- The creation of large tulip-only marketplaces.
Similar to today, the wealthy, well-educated, and experienced investors hopped on Tulip Mania next.
During the euphoria stage, investors from the excitement and boom stages start getting rich – at which point everyone starts to notice and invest.
Nothing defines the euphoria stage better than the “tendies” or “gains” posts on the high-risk investing subreddit r/WallStreetBets (read more about that in my article: What Is r/wallstreetbets, And Should You Take Their Investing Advice?). These are posts where amateur investors show off how much they’ve made, or what they’ve bought, during the boom phase:
The euphoria stage sends thousands (if not millions) of non-investors into a FOMO-induced fervor. The fear of missing out on society’s latest gravy train is such a powerful motivator that the euphoria stage of an economic bubble actually creates new investors.
During GameStop’s euphoria stage, over two million people downloaded Robinhood just to buy shares of GME, according to the Washington Post.
Similarly, by 1635, pretty much everyone in Dutch society was trying to buy up tulips, regardless of wealth or vocation.
As you probably suspected, prices during the euphoria phase reach their absolute peak: GME hits $320, or a single Dutch tulip goes for the price of a mansion.
But nobody believes – or wants to believe – that prices are peaking.
Less experienced investors hold on and hope.
But more experienced investors decide it’s time to cash in their chips and exit the casino.
During the profit-taking stage, experienced and institutional investors start to pull out. This causes prices to begin slowing down and leveling off, which signals other experienced investors to begin heading for the exit, too.
In some cases, these experienced investors are pulling out because they’re seeing signs of an economic bubble. Other times, they knew they were a part of an economic bubble all along, and are just getting out while the value of their investment is at or near its predicted peak.
After all, even if you recognize that GameStop is in an economic bubble, it still makes sense to buy at $50 and ride the wave to $300. The trick is knowing when to get off the ride.
By around 1637, more and more Dutch tulip merchants realized that paying $500,000 for a single tulip bulb was, well, ridiculous.
So, they sold off their tulips while the gettin’ was good. Wise investors will do this slowly so they don’t spook the market and tank the value of their remaining assets.
To be fair to amateur investors, experienced investors often have access to tools, tips, and scuttlebutt that the common man doesn’t. In the late 1630s, for example, prominent Dutch merchants were the first to realize that their big tulip contracts were no longer getting filled.
That was a massive red flag that something was wrong, which leads me to the other catalyst of the profit-taking stage: defaults.
Remember when I said one tulip could cost as much as a house? Well, since most Dutch citizens couldn’t afford tulips, they’d take out massive loans to get them. And since banks and creditors also thought the tulip market was bulletproof, they were happy to underwrite subprime loans to totally unqualified borrowers.
To summarize, the profit-taking stage is characterized by:
- Experienced investors starting to pull out.
- Rising default rates.
- Asset prices finally tapering off.
The euphoria is over, prices aren’t skyrocketing anymore, and experienced investors are whispering and tiptoeing towards the exit.
Then, someone pulls the fire alarm.
As the name implies, the panic stage occurs when everyone tries to pull out.
Experienced investors sprint for the exit, liquidating their holdings before prices hit rock bottom. Less experienced investors cling to hope. Anyone who purchased the asset using credit faces dire consequences with their creditors, who are also pretty screwed themselves.
Yeah, the panic stage is a mess. At least r/WallStreetBets has a sense of humor about it:
Economists often point to a needle that “pricks” the bubble.
During Dutch Tulip Mania, it was the bubonic plague. The Dot-com crash happened when tech startups ran out of capital. Some even say Elon Musk popped the Bitcoin bubble when he announced that Tesla would stop accepting BTC as payment.
How can you spot an economic bubble forming?
Hindsight is 20/20. It’s easy to look back at past economic bubbles and go, “Gee, that was dumb – what were they thinking?”
But spotting economic bubbles is more of a gut feeling than a precise science. And spotting them while they’re happening is trickier still.
Here are a few telltale signs that a particular investment is in an economic bubble:
- The prices are outlandish. Circling back to our OG definition, an economic bubble forms when the market price of an asset skyrockets past its fundamental price. Therefore if you find yourself looking at prices and thinking, “ya gotta be KIDDING me,” that asset is probably in a bubble.
- Headlines are filled with “frenzy” and “mania”. As mentioned above, the media tends to inform us of (and propagate) existing economic bubbles.
- Investing subreddits are going nuts. It might be worth subscribing to r/investing and r/WallStreetBets just to keep an ear to the ground. To their credit, these subreddits sometimes warn you of economic bubbles, whether they mean to or not.
- People with no financial background are encouraging you to buy. Is your old college buddy evangelizing a new investment opportunity without fully understanding it? That’s the definition of speculation and a major catalyst for economic bubbles forming.
- Folks talk about “getting rich quick” off of the asset. It’s not impossible to get rich quick in this country, but it always involves an unacceptable amount of risk. That’s why most rich people got that way by getting rich slow. If the asset is suddenly touted as a financial cure-all, there just might be a bubble on the horizon.
Should you invest during the boom stage?
Investing in bubbles is extremely risky because you simply don’t know when the bubble’s gonna pop.
In 2020, the COVID-19 pandemic accelerated the boom stage of the ongoing Bitcoin bubble. At the time, even crypto CEOs who acknowledged that BTC was in the boom/euphoria stages of a bubble still believed it would hit at least $100,000 in 2021.
Not one of them predicted that Tesla would yank the cord, ushering in a premature profit-taking stage and sending prices plummeting 50%.
Bubbles can burst at any minute
Good investing is based on fundamentals. Ever wonder why your 401(k) always returns 6% to 10% every year? Someone built it using math and stats – specifically, an “asymmetric risk profile” where the house always wins, so to speak.
Bubble investing can’t fit into an asymmetric profile because it’s too unpredictable. When an asset’s market value is upheld by speculation, not math, you can’t predict when it’s going to come tumbling down. Investing during a bubble, even in the boom stage, amounts to gambling.
If you’re ever unsure whether a financial move is right for you, trust your gut – (investing should be boring, cold, and calculating, says Warren Buffet). Before you get swept up in the momentum, do your own research, and talk to your financial advisor.
Is it safe to buy a house or a car during a bubble – or should you wait?
If you take out an auto loan or a mortgage during an economic bubble, you run the risk of the bubble popping and suddenly owing more on your loan than the asset is worth. This is called being “underwater” on your loan, and in a word, it sucks.
Who wants to owe $10,000 on a thing they don’t even have the keys for anymore?
That being said, it’s a little safer to invest in a home than a car during an economic bubble. Here’s why:
Cars are risky business in an economic bubble
Let’s say there’s an economic bubble for new cars at the moment, so a car you’d normally buy for $25,000 is selling for $30,000. You’re irked, but $5k isn’t that bad of a premium, so you consider it.
The problem with this scenario is that if you buy the car and the bubble bursts, your car could lose too much value too quickly:
- When the bubble bursts, the car settles back down to its fundamental value of $25,000.
- Now that you’ve driven it off the lot, it drops to a used car value of $20,000.
Within weeks of buying a car during a bubble, your $30,000 investment could have a True Market Value of just $20,000. Since you took out a $30,000 loan, you’re now $10,000 underwater. If you total it tomorrow, the insurance will pay out $20,000 minus your deductible – which means you’ll still owe $11,000 on a car you don’t even have anymore.
So buying cars during a car bubble is extremely risky business, and if you can wait, wait.
Houses are a little different.
Houses might be OK to buy in a modest bubble
It’s a little safer to buy a house than a car during an economic bubble.
For one, houses tend to appreciate in value over a long period of time – cars depreciate the day you buy them.
Also, most homeowners will own their homes for at least 10 years. As long as you have consistent income during those years, it’s considered somewhat safe to buy a home that you can afford and ride out a temporary housing bubble.
Economic bubbles occur when hope, FOMO, and pure speculation drive the market price of an asset well beyond its fundamental value. Bubbles are dangerous to anyone with a financial plan, since they can form up and burst without warning, costing you $1,000s.
However, if you can learn to spot bubbles by watching out for the signs, you can avoid them and buy when the time is right.
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