Ever wondered what the dot-com bubble and the housing bubble had in common? We have the answers!
A financial or economic bubble occurs when the cost of a particular asset rises above its fundamental value. This “fundamental value” of an asset is not a specific figure but rather a spectrum of values. So, when people wrongly estimate that the value would skyrocket, they keep on buying that asset.
Finally, as demand increases, so does the price. When that happens, other investors jump in and purchase those assets which have skyrocketed in price because it looks like a good deal to them, too. This is called the “boom”. During the boom, asset holders who notice that the asset will eventually drop in value will start selling at higher prices to make bank. This results in an avalanche of people wanting to sell, and a self-perpetuating cycle of decreasing prices starts. This is why a bubble is called a “bubble”—it eventually bursts.
Now that you know what a bubble is, let’s take a look at three historical bubbles and what are the common patterns we can observe between them.
Tulips arrived in Western Europe in the late 1500s. Since the tulip was an exotic flower, it became a status symbol for wealthy Dutch merchants. The tulip bulbs, which had unique colors, were highly priced because of their rarity.
By 1936, the entire Dutch society went into a frenzy to buy exotic tulips. With a surge in demand, there came a surge in prices. People began spending a year’s worth of their salary on rare tulip bulbs, hoping to resell them for a profit. It is believed that the Tulip Mania was not as big a bubble as it is understood today, as historians say that they couldn’t find anyone who went bankrupt because of this bubble.
The dot-com bubble
In the 1990s, the internet was rapidly gaining popularity. As the internet became more popular, people began investing in speculative internet-based businesses. Instead of focusing on company analysis, the investors focused on the traffic that the websites were receiving and wrongly estimated the websites’ values.
The internet bubble reached its peak in March 2000 when the NASDAQ Composite stock market index rose above 5,000, after which it crashed. The index plunged by 80%, triggering a recession in the United States.
The 2008 housing bubble
The U.S. housing bubble of 2008 was a direct consequence of the rise in real estate prices. Between 1996 and 2006, the price of housing in the U.S. nearly doubled. This was because, in 1999, the Federal National Mortgage Association began a concerted effort to make mortgages accessible to those with less than perfect credit and savings.
Originally, lenders could get out of these mortgages by selling their houses for a profit, but when prices crashed, this no longer was the case. Between 2001 and 2007, the national mortgage debt in the U.S. almost doubled, and banks that had lent the money suffered losses as well.
So, what can we learn from them?
In all three bubbles, there was a rush to pour money into something that was seemingly sure to make money. However, in all three cases, investors didn’t conduct thorough due diligence to understand the asset they were investing in.
In the case of Tulips, investors lost track of rational expectations, and that cycle has continued for other financial bubbles that followed it. For the housing bubble, the practice of making housing loans accessible brought with it the risk of loan defaulters who didn’t have enough resources to own homes, to begin with. During the dot-com bubble, people put money into something without any markers of solid profitability.
However, ultimately, all three crises have taught us the same lesson—to be careful in where we invest and not to aimlessly follow the gold rush. Avoid herd mentality and follow quantifiable metrics while making your investment decisions.
This is a particularly important lesson when we put into perspective that we are in the middle of yet another speculative bubble, and that is that of crypto. Michael Burry, one of the investors who made money from the housing bubble, foresees the mother of all crashes in the crypto market in the future. Similarly, for non-fungible tokens (NFTs), some crypto investors have been signaling trouble, with the NFT market pulling in US$2 billion a month. Whether these assets end up as bubbles or continue to stay relevant over time is yet to be seen.
Header image courtesy of Unsplash