When the bubble bursts: Understanding the phenomenon and preparing to respond

Most investors fear the term “bubble burst” more than any other phrase because it signifies a major loss, economic collapse, and shattered confidence. But to protect ourselves, we must first understand what causes a bubble burst.

What determines a bubble burst

A bubble burst is a phenomenon where asset prices rise abnormally, far beyond their intrinsic value. When driven primarily by speculation and overconfidence among investors, this expansion continues until reaching a peak. Then, reality sets in: the bubble bursts, prices plummet, and many investors are caught off guard.

Asset values decrease sharply, as if a balloon suddenly deflates. This pattern has repeated throughout history, and each time it occurs, the consequences are numerous.

Lessons from the past: Looking back

The 2008 Subprime Crisis – The Collapse of the US Real Estate Market

From late 2007 to early 2008, the US faced a significant downturn. Banks issued loans under normal criteria. People unable to repay their debts signed mortgage agreements, borrowing heavily. Many did not buy a “home” but speculated on rising prices.

Financial institutions created many complex financial instruments linked to these loans. They entered the global market. Investors worldwide, eager for returns, fueled an unsustainable real estate boom.

When borrowers began defaulting, everything collapsed—like dominoes falling one after another. The global financial system trembled. Bad debts soared, with banks estimating losses of up to 1.5 trillion yen or about $15 trillion USD.

Lesson: Borrowing excessively for long-term asset speculation is a recipe for failure.

The 1997 Asian Financial Crisis – Thailand and Southeast Asia in Ruin

At the same time, Thailand was in a state of artificial prosperity. Interest rates soared, yet the real estate sector continued to flourish. Foreign capital flowed in. Local investors and foreign financiers saw profit opportunities.

The real estate bubble inflated rapidly. Loan demand increased, and property prices soared to irrational levels.

On July 2, 1997, a turning point: the baht lost value, and foreign currency contracts by investors expanded. Non-performing loans surged as many real estate loans defaulted. The economy unraveled. Thailand plunged into a severe recession.

Damage: Not just Thailand—other regional countries also fell into crisis.

Various types of bubbles

Bubbles are not limited to real estate. They can form in any asset class.

Stock Market Bubble: Stock prices soar beyond earnings, assets, and company performance. This can impact individual stocks, entire markets, ETFs, or specific sectors.

Broad Asset Bubble: Not just stocks—currencies like the dollar and euro, cryptocurrencies like Bitcoin and Litecoin can also bubble when prices rise unsustainably.

Credit Bubble: When lending to consumers and businesses expands excessively, creating a fragile situation. Small economic shocks can trigger widespread defaults and chaos.

Commodity Bubble: Gold, oil, metals, agricultural products—prices spike due to heavy speculation. When supply increases or demand drops, the market collapses.

The five stages of the cycle

Stage 1: Excitement

New innovations arrive: new technology, low interest rates, or industries believed to change the world, such as the dot-com era.

Stage 2: Capital inflow

Investors say “I don’t want to miss out” and rush in. Money floods in, prices rise, and as prices climb, more investors join, creating a positive feedback loop.

Stage 3: Euphoria

Investors believe prices will keep rising indefinitely. Risks are ignored, and greed drives prices to unbelievable levels.

Stage 4: The pause

Some notice that asset prices are too high and decide to lock in profits. Selling begins, and volatility appears.

Stage 5: Panic

A large number of investors start selling simultaneously. Prices plummet, and the bubble officially bursts.

Common reasons: Why do bubbles form?

Economic factors: Low interest rates encourage borrowing and spending. A strong economy attracts foreign investment. New technologies excite markets.

Psychological factors: Humans tend to follow the crowd. Herd mentality reinforces market entry. Short-term thinking and belief that they can exit before the bubble bursts. Financial biases cause us to accept only information supporting our beliefs.

Depth of the bubble: Prices are driven not by fundamentals but by the blood, sweat, and speculation of traders. The combined effect of these large factors creates an unsustainable cycle that eventually bursts.

How to protect yourself

Review your objectives: Invest because you understand, not out of fear of missing out or because others are doing it.

Diversify: Don’t put all your eggs in one basket. Decide to invest in different asset classes so that when one bubble bursts, you still have options.

Avoid excessive speculation: If you suspect a bubble is inflating, limit your exposure. Remember: these are the assets that fall fastest.

Invest gradually: Use dollar-cost averaging (DCA) to extend your investment horizon instead of investing everything at once.

Keep cash: Liquidity is quite convenient. It allows you to benefit from price declines after a bubble bursts and serves as a safety net.

Study the market: Knowledge is the best defense. Follow information, research, and analyze before making investment decisions.

Summary

A bubble burst is not an accident; it is an inevitable result of market cycles. When prices soar beyond their true value, fueled by speculation, overconfidence, and ignorance, the truth eventually catches up.

History plays a role— the 2008 financial crisis and the 1997 Asian crisis confirm this, causing widespread losses, broad consequences, and difficult futures.

What we can do is prepare: diversify, educate ourselves, think long-term, and act cautiously. Bubbles are part of markets, but they don’t have to be personal disasters.