Bubble
Also written Speculative bubble · Asset price bubble
In Kindleberger's description, a sharp, continuous rise in an asset's price in which early gains create expectations of further rises and draw in speculators seeking trading profits.
In plain language
A price starts rising for a good reason — a new product, a new idea, higher productivity. Early buyers make large profits. Others notice and buy, pushing the price higher, which draws in still more buyers. Eventually the price has little to do with value.
Charles Kindleberger, in Manias, Panics and Crashes (1978), describes a bubble as a sharp rise in asset price in a continuous process, with the initial rise generating expectations of further rises and attracting new buyers — generally speculators interested in profit from trading rather than investing for the long term.
In his view, psychology is as important as finance and economics in explaining this behaviour. A crash is the same process in reverse: everyone tries to sell at the same time.
How it works
Why rational arbitrage does not stop it (Chapter 14, section 14.5.2). Arbitrageurs should sell a mispriced asset until the mispricing disappears. But they face a synchronisation problem (coordinating their selling) and different individual incentives to time the market. So bubbles persist longer.
How bubbles typically develop. They often emerge during structural changes in productivity — the railway, electricity and technology booms. A justifiable rise comes first; early investors earn very high returns; cheap borrowing fuels more buying; prices reach unrealistic levels; analysts produce "new age" theories to justify them.
Potential reasons the workbook lists: liquidity, celebrity status (media-promoted), momentum (extrapolation leading to herd trading) and illusion of control.
Keith Redhead (2008): bubbles are more likely where —
- the proportion of inexperienced traders is high;
- uncertainty about true value is high;
- there is a small chance of a very large profit;
- purchases can be financed by borrowing;
- short selling is difficult.
Crashes follow similar processes in reverse — negative news, a change in opinion, a liquidity crunch or a return to fundamental pricing makes everyone rush to sell first.
A worked example
The workbook's own numbers — Isaac Newton and the South Sea Bubble. Kindleberger notes that Newton rode the bubble in 1720. He got out at GBP 7,000 after making a profit of GBP 3,500, then decided to re-enter and ended up losing GBP 20,000. His verdict: "I can calculate the motions of heavenly bodies, but not the madness of people."
An illustrative Indian version. A small listed company announces a move into a fashionable new technology. Its share goes from ₹100 to ₹180 in three months (+80%). Media coverage follows. Retail investors, many trading for the first time, buy on margin. Short selling in the stock is hard. The price reaches ₹600 while the company's earnings have not changed at all. Every one of Redhead's five conditions is present.
Then the company reports that the new business will take years to earn revenue. Everyone tries to sell at once. An investor who bought 1,000 shares at ₹550 (₹5.5 lakh) and sells at ₹150 receives ₹1.5 lakh — a loss of ₹4 lakh, larger still after interest on the margin loan.
Why NISM asks about it
Chapter 14 (Behavioural Finance), section 14.5.2, explains bubbles and crashes: Kindleberger's definition, the synchronisation problem for arbitrageurs, historical examples, the four potential causes and Redhead's five conditions. Expect questions on the definition, the conditions that make bubbles likely, and why arbitrage fails to correct them.
Common exam traps
- The workbook's dates disagree. Section 14.5.2 lists the "South Sea Bubble of 1729–30", then in the next sentence says Newton rode the South Sea Bubble in 1720. Both appear on the same page (Chapter 14, p. 248); the XXI-B chapter notes flag the same inconsistency. If asked when Newton rode it, the workbook's answer is 1720.
- Bubbles often begin with a justifiable price rise. "Bubbles begin with no economic basis" contradicts the workbook.
- Easy short selling makes bubbles less likely, not more. Redhead's condition is that short selling is difficult.
- Borrowing fuels bubbles. Cheap credit is on the list.
- Kindleberger (1978) wrote Manias, Panics and Crashes; Redhead (2008) gave the five conditions. Do not swap them.
- Arbitrageurs fail because of synchronisation and incentives, not because they lack information.
Where this is taught
- Series XXI-B · Chapter 14: Behavioural Financeintroduced here
- Series X-B · Chapter 16: Basics of Behavioral Financeintroduced here
Related terms
- ArbitrageSimultaneously buying and selling an asset, or a replica of it, in different markets to profit from a price discrepancy — a trade that aims to lock in a profit rather than bet on direction.
- Behavioural financeThe study of how psychology shapes the decisions of market participants, individually and in groups, and how those decisions show up as gaps and anomalies in financial markets.
- Market anomalyA pattern of returns that departs from what an asset's fundamentals and risk — as measured by CAPM or another pricing model — say it should earn, and so contradicts market efficiency.
- Overconfidence biasAn emotional bias in which people place unwarranted faith in their own judgement and abilities — leading to underestimated risk, concentrated portfolios and excessive trading.
- SpeculationTaking on risk not commensurate with the return sought, in the hope of a large gain, with minimal research into what the asset is actually worth — the opposite of investing, and not merely the short-term version of it.
- Law of one priceThe principle that identical assets cannot trade at different prices in two markets, beyond the transaction costs between them — because arbitrageurs would close the gap.
- Illusion of controlThe belief that familiarity, information access or active involvement gives an investor influence over a price — which leads to a conviction that he can forecast it and sell out before everybody else.