What is a Financial Bubble?

In the economic and financial world one of the moments of more anguish and uncertainty is the one experienced after the bursting of what are known as Financial Bubbles. This happens because after the bursting of the bubble it is very common the occurrence of a period of crisis and economic depression.

Without going any further, today, we can still see the effects of the financial crisis of 2008, which occurred as a consequence of the bursting of the Real Estate bubble in the United States in the year 2006. This collapse, originated from the mortgages known as subprime (high risk mortgages), produced, among other things, the bankruptcy of Lehman Brothers, one of the major financial companies in the world.

The formation process of the financial bubbles is very clear. They are generated when the prices of a particular product or asset start to rise wildly, to such an extent that the price begins to distort, moving significantly farther away from its intrinsic or real value. This behavior leads new buyers to enter the market with the goal of selling the asset at a higher price in the future. This speculative process generates a continuous increase movement in the price of the asset, which moves increasingly farther away from its real value.

The prices reached by the asset can be so absurd that from one moment to another the asset ceases to be attractive and a sell-off is generated. At that point, no price is attractive enough to buy: THE BUBBLE HAS JUST BURST. The fall can be so sharp that the asset can even reach prices below its real value.

The first episode of this kind in recorded history is the one known as “The Tulip Craze”. This phenomenon, which occurred in Holland during the 17th century, arose when speculation drove the price of tulip bulbs to extremes. In 1635, it was paid up to 100,000 guilders for 40 bulbs; today this would be equivalent to more than half a million dollars. Like in any bubble, an upward spiral in prices occurred, which ended in 1637 with the bursting of the bubble, generating, as a consequence, a deep economic depression in the country.

Similar events to the previous one are the ones known as “The Crash of 1929” and “The Dotcom Bubble” (crisis of the year 2000 of the internet-based companies). Although in all those situations people live moments of anguish and uncertainty, it is a great opportunity for investors to take on bearish positions. Therefore, if we are trained and we can control our emotions, we can make very high returns in all these scenarios.

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