Hello friends of LeoFinance, I hope you are very well. I bring you a brief explanation of something that we hear mentioned very often lately when we see the news, of course, financial bubbles, I will try to explain, as clearly and simply as possible what they are, how they work, the types of bubbles and how to identify the signs of a possible bubble. Later in another post, we will move on to how to identify them in practice with the use of information available to everyone on the internet.

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What are economic bubbles?
An economic bubble is the phenomenon in which a stock, a company, or a financial sector in general has a market value much higher than its intrinsic value, and this high value is not justified by real existing assets of that sector. In other words, whoever buys shares of that company or in that sector where there is a bubble, is paying much more for them than they are really worth.

Due to market dynamics, and the fact that speculation is a legal and common practice, this would not be such a bad thing... the problem with bubbles is that they all 'Pop' eventually, as at some point people start to realize that the assets they are trading are not worth as much as the market has led them to believe, and when a bubble pops it usually does so all at once, leaving many broke, in debt or with junk stocks in their hands.
How does an economic bubble form?

Although economic bubbles are not a fully understood phenomenon, and experiments show that they can appear even in experimental economies run to perfection by multidisciplinary groups of experts. At present the most important and damaging economic bubbles can be attributed to two main causes.

1. Excessive Liquidity.

When an economic sector has a lot of money, but does not know where to invest it in the most efficient way, or if it does not have a good catalog of investment options, it may decide to invest in a stock, company or very specific sector, after that injection of capital, that asset or action happens to grow in price due to the basic law of supply and demand, this in turn starts a chain reaction in which the growth of the value of such shares lead others to invest in them to take advantage of future growth, This drives prices to unsustainable levels in the long run, because if something eventually happens that proves that those stocks are not as good an investment as speculation has made them out to be, or the source of excess money that financed those investments decides it wants its money back, the bubble bursts, investors start liquidating their shares en masse trying to flee the losses.

As in any flight for survival, the first ones to run have an advantage, but as the prices of those assets go down, some will not be able to sell at a price above what they bought, they are left behind, and they lose money because of the bubble, the one who made a loan to make that investment, is left with the debt, interest, and losses. These victims can have massive losses due to the dynamics of leverage.

The reasons for excess liquidity in the markets can be many, such as central banks printing bills without control, lax regulations, the abundance of credit with very low interest rates, the focus of most of the economic power of large companies in a single specific sector, and the focus of investments of many countries in one.

A classic example of an economic bubble due to excess liquidity that contains all the elements mentioned above is the economic bubble that caused the great economic crisis of 2008.

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At that time the US Federal Reserve continued with an expansionary monetary policy to avoid a possible economic recession, the injection of liquidity to the economy was done through the purchase of assets, usually to companies with strong investments in the real estate sector of the United States, which was seen at that time as an excellent sector to do business, this also attracted foreign investment, and in the midst of the speculative race, many housing loans began to be given with few requirements as many funds lowered their requirements to cover more market, yes, with floating interest rates, as the price of housing increased artificially, those people who received loans without having a clear ability to pay were hit by higher interest rates, and naturally began to defraud their loans, with floating interest rates, as the price of housing increased artificially, those people who received credits without having a clear capacity to pay were hit by higher interest rates, and naturally began to defraud their commitments, this generated panic, and many investors tried to liquidate their shares, this drove the price even higher, and when the investment funds realized that they had a lot of loans that were not going to be repaid, and they cashed them in by taking over houses that were worth less and less every day, even less than the initial loan was, they found themselves in an obvious labyrinth, the bubble burst. Everyone in the sector lost money, many ordinary people lost their savings and their homes, this put the economy into recession.

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For more detailed information I recommend this video.

2. Sociological factors. [Or psychological].

This part refers mainly to the natural irrationality of human beings. There are many factors that can lead human beings to overpay for something they want. Especially if this something comes with the promise of a greater reward than what is invested.

One such factor could be the emergence of a new paradigm, such as when a new technology appears and investors jump to put money into it because it promises to be something revolutionary and successful that is sure to sell a lot and grow and give them good returns.

Another would be the coercion of the hype, when you pump publicity about an asset, or make it look like the best possible investment many people will go out of their regular way to invest in it, this investment generates a trend that others will try to follow, turning the success of that asset into a self-fulfilling prophecy, but when the publicity proves to be misleading, the bubble will burst.

And speaking of trend, there are bubbles created by the human habit of extrapolation, that is, by assuming that because a stock has a long history of growth, it will continue to grow in the future, which causes investors to put their money into it, which in effect makes it grow, until something breaks the cycle and the bubble is discovered.

Since human psychology is infinitely diverse, and Behavioral Economics is not yet a perfected science, I can't claim to cite even a fraction of the things that might lead a person or group of people to overinvest in a stock. But it is worth noting that psychology plays an important factor.

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An example of an economic bubble due to psychosocial factors is also one of the oldest examples of an economic bubble of which there is a complete record. The tulip mania in the 1630s in Holland, where the taste of the elites for tulips as decorative ornaments drove a fashion, a race among botanists and a speculative boom that led to some varieties of tulip bulbs being worth as much as a small mansion, The business became so prolific that many people sold their property or lent money to invest in tulip bulb futures stocks. When the fad passed, partly because of the excessiveness and absurdity of it all, and tulips were devalued, many people lost everything. I recommend this video about it.

Now, going back to the basic theory of financial bubbles, let's talk a bit about the phases of development.

These we can group into 5 phases.

1. Displacement.

This is the initial phase, where liquidity injections occur in the case of those caused by this, or the new paradigm appears, the new technology, or the Hype bell takes effect in the case of those caused by sociological causes.

2. The Boom.

In this phase we see how the injection of money or the entry of new investors in the specific shares begin to attract attention as the price begins to rise to higher levels than usual, this in turn becomes its own advertising campaign, as it begins to generate FOMO and make investments in that asset seem like a once in a lifetime opportunity.

3. Euphoria.

At this point the concern is long gone, as the price increase exceeds all previous metrics, and in the investors' minds it does not matter how expensive they buy the shares, they will always be able to sell them at a higher price and make a profit.

4. Profit-taking.

At this point older investors, realizing that they are navigating a bubble, begin to see the danger signs of the bubble and begin to liquidate their assets. Making massive profits as usually these seasoned investors noticed the signs that a bubble would appear long before the bulk of the population and decided to take advantage of it, usually the amounts of money invested by these players are large, as unsurprisingly to no one, they are successful traders. This obviously slows down, or eliminates the rise in prices, which becomes a sign that the bubble is going to burst, although usually these veteran traders do not know the exact moment when the bubble will burst, they play it safe. Since the market can remain irrational for longer than anyone can be solvent.

5. Panic.

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Once an event, no matter how small, makes investors lose confidence, and the first ones leave, panic sets in as the fear of losses, especially on the part of those who are more committed, starts to make everyone start liquidating their assets, the law of supply and demand operates and stock prices go down, this in turn generates more panic, it is a vicious circle that ends up destroying the bubble and everyone who has been trapped in it.

And with that, my friends, I end the first part of this post. Now that we know the basics about financial bubbles, how they can affect us, and we know some of the characteristics they have, we are in a better position to start learning how to identify them, but in order not to make this article a very extensive reading, we will address that in another article.