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4 Notable Economic Market Bubbles in History

4 Notable Economic Market Bubbles in History

Following up on What Are Fractional Shares, this week we’ll discuss market bubbles and review four economic bubbles in financial history.

"The most important quality for an investor is temperament, not intellect. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd." -Warren Buffett


Defined, a market bubble is a rapid rise in the price of stocks or other assets that is not justified by fundamentals and is followed by a sharp fall in prices once investor enthusiasm wanes.

As a stock or other asset's price rises, more and more investors see the rising prices as an opportunity to profit. Eventually, the bubble bursts when enough investors realize the price of the asset has become detached from its true value and begin to sell all at once.

Bubbles are typically marked by a prevalent story, such as the idea that a new technology or new way of thinking has permanently transformed the market.

There is a self-perpetuating cycle where people want to buy an asset because its price is increasing, driving the price even higher and making even more people want to buy it.

Warren Buffett advises the opposite approach. Don't buy certain stocks just because everyone else is. Yet don’t aim to always be a contrarian and sell the stocks that everyone else is buying. Instead, he suggests ignoring the crowd entirely and focus on finding value on your own.

A company's valuation should be determined by its business fundamentals -- its profits, growth rate, and other factors. In a bubble, speculation and euphoria take over.

Four famous bubbles include:

Tulipmania: One of the earliest examples of market bubbles dating to the 1630s in Holland, tulipmania struck Holland in the 1630s as the price of Dutch tulips rapidly surged,far beyond their worth.

By 1636, the demand for the tulip trade was so large that regular markets for their sale were established on the Stock Exchange of Amsterdam, in Rotterdam, Haarlem, and other towns.

During the peak of the tulip bulb market bubble, the prices of some of the most prized tulip bulbs were roughly in line with the price of a house in Holland at the time.

On February 3, 1636, a bulb didn’t sell at an auction in the Dutch city of Haarlem and that failure to sell caused prices to drop. The bubble was over, with the flowers eventually selling for a fraction of their peak prices.

Similar to the 1929 Market Crash, a large part of this rapid decline was driven by the fact that people had purchased bulbs on credit, hoping to repay their loans when they sold their bulbs for a profit. But once prices started to drop, holders were forced to sell their bulbs at any price and to declare bankruptcy in the process.

One of the curiosities of the tulip market was that people did not trade the flowers themselves but rather the bulbs of scarce and sought-after varieties. Tulips even began to be used as a form of money in their own right: in 1633, actual properties were sold for handfuls of bulbs.

South Sea Bubble: The South Sea Bubble of 1720 was the financial collapse of the South Sea Company in 1720. The company was formed in 1711 in London and its purpose was to supply 4800 slaves each year for 30 years to the Spanish plantations in Central and Southern America.

Britain had secured the rights to supply slaves to Spanish America at the Treaty of Utrecht in 1713. The South Sea Company bought the contract from the British government for £9,500,000.

It was also assumed that the profits from slave trading would be enormous, which proved not to be the case.

By the end of April 1720, stock was selling at almost £350, then nearly £600 by the end of May, and £950 by the end of June. In September of 1720, the bubble burst. Stocks plummeted, down to £124 by December, losing 80% of their value at their height. Investors lost thousands, there was a marked increase in suicides and there was widespread anger and discontent in the streets of London with the public demanding an explanation.

Isaac Newton is said to have invested early, and cashed out with 100% profits as market valuations went to what seemed to him unjustified levels. However, as prices continued to advance, he supposedly invested again at the peak and lost most of his fortune in the crash that followed.

He is quoted to have said that he could ‘calculate the motions of the heavenly bodies, but not the madness of people’, and supposedly could not bear to hear of the South Sea affair to the end of his life.

Dotcom bubble: The dotcom bubble, also known as the Internet bubble, grew out of a combination of the presence of speculative investing, the abundance of venture capital funding for startups, and the failure of dotcoms to turn a profit. Investors poured money into Internet startups during the 1990s hoping they would one day become profitable.

Valuations were based on earnings and profits that would not occur for several years if the business model actually worked, and investors were all too willing to overlook traditional fundamentals.

The late 1990s saw many Internet-focused companies filing for initial public offerings (IPOs). Many investors were eager to invest—even in shares of companies that didn’t prove to have sustainable business models, like, which liquidated less than one year going public. As some individual companies collapsed, that led to a broader crash in the stock market.

Then the bubble imploded. As the value of tech stocks plummeted, cash-strapped internet startups became worthless in months and collapsed. The market for new IPOs froze. On October 4, 2002, the Nasdaq index fell to 1,139.90 units, a fall of 77% from its peak.

The U.S. housing bubble: The subprime mortgage crisis was one of the main contributors to the 2007-2008 global financial crisis.

Interest rates from 2000-2003 were lowered from 6.5% to 1% due to the dotcom bubble and the Sept. 11, 2001 terrorist attacks. Low interest rates provided cheap credit and more people borrowed money to purchase homes. This demand helped lead to the increase in housing prices.

By the mid-2000s, a bubble began to form in the U.S. housing market amid a very rapid acceleration in home prices. Speculators began to flip homes in hopes of making a profit, and the average price of a U.S. home increased almost 80% between 2000 and 2006. The bubble eventually burst.

The subprime mortgage crisis severely weakened the global financial system. The crisis and the subsequent global financial crisis caused $7.4 trillion in stock market paper losses, and wiped out about $3.4 billion in real estate wealth.

One way to preserve your portfolio's value during the bursting of a stock market bubble is to only hold stocks with strong business fundamentals.

Another way to protect your portfolio during a stock market bubble is to buy put options, which enable you to sell stock at a pre-determined price within a certain time period.