A financial bubble can be described as a phenomenon wherein an asset or an asset class trades at a value that far exceeds its intrinsic value.
We know that unless the market for an asset is regulated, it is the market forces of demand and supply which determines the price at which the asset is traded for.
In a typical scenario, this market-determined price more or less reflects the ‘intrinsic‘ value of the asset. A financial bubble is an exception to this.
Typically a financial bubble will have the following characeristics:
- There is wide-spread euphoria surrounding an asset class which causes it to trade at excessively premium valuations.
- As more and more people buy into the asset class with complete disregard to valuations, its price increases rapidly leading to huge gains for its holders.
- Buoyed by these phenomenal gains, yet more people are drawn in because of their ‘fear of losing out‘; leading to the asset trading at astronomical valuations.
- The ‘bubble’ bursts when there is a large sell off either due to a liquidly crunch or an event surfaces which proves that the asset may not be as ‘valuable’ as was previously thought – leading to panic selling and eventually a market crash.