Warning! When the bubble bursts and how to prepare

When you hear the news that “a bubble is bursting,” many investors feel panic over potential losses. A bubble is an economic cycle that repeats itself: asset prices soar beyond their true value, then suddenly decline, causing many to suffer losses.

What is a bubble: When asset prices rise excessively

A bubble burst occurs when asset prices, such as stocks, real estate, or digital currencies, fluctuate outside of their actual worth. This unreasonable price support often results from market manipulation, investor panic, and the belief that “prices will keep rising.”

But this cannot last forever. The truth eventually emerges: people realize they are paying more than they should. When the market shifts direction, prices suddenly fall, like a fully inflated balloon that suddenly pops. As a result, many investors lose a huge amount of money.

Balloons expanding to capacity: 3 main types of bubbles investors should know

Bubbles are not limited to the stock market; they can appear in various economic systems in different forms.

Stock market bubbles occur when stock prices increase faster than the company’s earnings. Usually, we look at revenue, assets, and overall performance, but sometimes investors ignore these fundamentals, driving prices higher.

Asset bubbles are broader. Real estate is a classic example, with property prices supported by expectations of continued growth. Additionally, currencies and digital assets like Bitcoin and Litecoin have histories of bubbles.

Commodity bubbles affect prices of gold, oil, and industrial metals. Excessive demand driven by intense trading pushes prices beyond sustainable levels. When supply increases or demand drops, everything crashes.

Excessive behavior: Psychological factors driving bubbles

Bubbles are not solely caused by economic factors; psychology plays a significant role.

When you see asset prices rising steadily, psychological risks emerge: Fear of missing out causes people to rush in, even if they don’t understand the true value. This is the “herd phenomenon,” where people follow the crowd without careful thought.

Overconfidence makes investors ignore warning signs and focus only on information confirming their beliefs. They tell themselves, “This time is different,” even as history repeats itself.

Other economic factors, such as low interest rates, encourage borrowing and investing. A strong economy attracts foreign capital. All these factors combine to push prices to unrealistic levels.

5 steps before a bubble bursts: Recognize warning signs

Understanding the cycle of bubbles helps you spot warning signs before a major event.

Step 1 - Emergence of new things: New technologies, exciting industries, or investment opportunities that seem to transform the economy (like the dot-com bubble). People start paying attention.

Step 2 - Rapid valuation increase: As interest grows, investors flood in, pushing prices higher. A positive feedback loop forms: high prices → perceived profits → more investors → even higher prices.

Step 3 - Peak enthusiasm: The market is full of hope that “prices will keep rising.” Investors become overly optimistic, telling positive stories about their investments, even if fundamentals don’t support it.

Step 4 - Profit-taking begins: Some realize “prices are very high” and start selling. This is the first sign that confidence is waning. Multiple sellers cause volatility.

Step 5 - Panic: When prices fall, many investors watch and realize “the bubble has burst!” Everyone rushes to sell, causing rapid declines. The bubble officially pops.

Lessons from historical crises

History is full of bursting bubbles, some causing great damage.

2008 US financial crisis: Originated from a real estate bubble. Financial institutions approved mortgages to borrowers unable to repay. These loans were bundled into complex securities. Many believed house prices would keep rising. When defaults increased, the system collapsed. Property prices plummeted, mortgage-backed securities lost value, and global debt reached $150 billion. The crisis severely impacted the world economy.

1997 Thai Baht crisis: Similar but with different details. Rapid growth in real estate, high interest rates, and foreign investment created a bubble. On July 2, 1997, the Baht was devalued, causing foreign-denominated debt to soar. Many borrowers couldn’t repay, and the real estate bubble burst, leading to a severe economic downturn in Thailand.

Both examples show that short-term borrowing to invest in long-term assets is a recipe for disaster. When the bubble bursts, debts become burdens, but assets cannot be sold easily.

Defensive strategies: How to avoid major losses

While we cannot prevent bubbles from forming, we can protect ourselves.

Reassess motivations: Before investing, ask whether you’re genuinely interested or just afraid of missing out. Do you understand the asset thoroughly? If not, you may be contributing to the bubble.

Diversify investments: Don’t put all your eggs in one basket. Spreading risk reduces the chance of large losses if one market crashes while others remain stable.

Avoid speculative assets: If you suspect a bubble, steer clear of highly speculative assets. These tend to fall fastest when the market turns.

Invest gradually: Instead of investing all at once, use dollar-cost averaging—invest small amounts over time. This helps avoid buying at market peaks.

Keep cash reserves: Having cash allows you to seize opportunities after a bubble bursts. It also provides safety during economic downturns.

Learn and monitor: Knowledge is the best defense. Follow market trends, ratios, and warning signals. Research thoroughly before investing.

Summary: Bubbles are inevitable, but you don’t have to be harmed

The causes of bubbles about to burst stem from human behavior: soaring prices fueled by hope, crowds rushing in, and everyone believing “this time is different.” When realization dawns that prices are too high, everyone rushes to sell, causing sharp declines.

Bubbles are part of market dynamics, but you don’t have to suffer losses. By diversifying, studying markets, avoiding hype, and thinking carefully, you can protect your assets. Even if prices are high and markets volatile, understanding the situation helps you stay prepared as the balloon deflates.