What is a financial bubble?
A bubble refers to a situation where the price of an asset, such a stock, exceeds its fundamental value by a large margin. Financial bubbles can be categorized as stock market bubbles, market bubbles, credit bubbles, and commodity bubbles. Bubbles are created when speculative demand fuels inflated prices rather than intrinsic worth, leading to an eventual pop and spectacular crash. The burst of the dotcom bubble in 2000 and the real estate bubble in 2008 resulting in severe recessions in the U.S. are examples of past financial bubbles.
The 5 stages of a bubble:
Financial bubbles can be broken down into 5 key stages:
- Displacement – The first stage, displacement, occurs when investors become fascinated by a new concept or product, such as a new innovative technology.
- Boom – During the boom, prices rise slowly and then gain momentum as more investors enter the market.
- Euphoria – The euphoria phase sees asset prices skyrocket as more investors jump on the trend, causing valuations to reach extreme levels.
- Profit-taking – At this point, smart investors anticipate the bubble bursting and start to sell their stocks and take profits. However, it is extremely difficult to estimate the exact time a bubble is about to collapse.
- Panic – Once the “smart money” starts to sell, asset prices reverse and descend rapidly as more and more investors exit.
Tips to prepare for a bubble:
- Maximize your liquid savings – Ensure you have sufficient liquid savings such as checking, savings, and money market accounts to use in a crisis. These resources won’t fluctuate with market conditions and should be your first resources to turn to if a bubble bursts.
- Make a budget and stick to it – A monthly budget is essential to keeping track of your financial health and helps you determine how much money you need for your emergency fund.
- Minimize and monitor your monthly bills – Analyze your existing bills and look for areas to cut down which aren’t a necessity. Reducing your monthly expenses will help you pay your bills if a financial bubble bursts.
- Pay off high-interest debt – Try to pay off debt such as credit cards in order to reduce your monthly interest charges and provide extra cash for financial crises. Additionally, search around for better credit card deals with lower rates if you often struggle to pay your credit card bills on time.
- Maintain a diversified portfolio – Financial bubbles severely impact investors with undiversified portfolios. Minimize risk by investing in a variety of asset classes and industries to avoid losses if one industry experiences a bubble burst.
- Adopt a long-term outlook – Avoid investing in the next hot product and panic-selling when stock prices start to drop. The market will eventually recover and maintaining a long-term outlook will help you ride out the storm.
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