Finance Essay Sample: Behavioral Finance Explains Bubbles

The term bubble has featured in many conversations especially when talking about technology or housing investments (Nash, 2013). Although economics state that the market may experience a period of boom and bust, bubbles are not a traditional economic development and have a different meaning. A bubble is a market phenomenon that is caused by mass euphoria about a certain product which makes the price of the service or good surge beyond a supportive value. Some of the most common bubbles include the housing and the internet crisis. People were willing to buy houses at exaggerated prices with the aim of selling them at a profit. However, at a certain point, the prices were not sustainable and the prices dropped drastically as many people tried to sell their house at once. The same situation occurred in the 90's during the advent of the internet. Everyone wanted to invest in technology and the shares went abnormally high.

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A bubble has some distinct steps that it undergoes before it burst and goes back to normal. The first step is take off. During this stage, the product is introduced in the market by the creators. The second stage involves the first sell-off of the product to the investors. The media attention is the third stage which is followed by enthusiasm. As the profit prospects increase, people start becoming greedy and this is when the demand for the product becomes huge. The prospect of becoming super rich makes people delusional and they start purchasing shares or product irrationally. However, the demand does not go on for long and a new pattern in the market emerges. First, people will start to see the prices of their investment decline as the demand reduces (Nash, 2013). The first reaction that most people have will be denial and hope that the prices will go back up. However, this is usually not the case and as the prices go down investors start being fearful. Investors realize they are losing money and they give up any hopes of recovering their funds. Finally, people enter a phase of despair as their investments go to a negative value before it comes back to a normal level.

The two common factors that have been found to cause a bubble are uncertainty and liquidity/leverage. In every bubble that has occurred, there has been a financial incentive. The availability of cash when an innovation occurs encourages individuals to invest their money and cash out when the price is high enough. Logic dictates that people will invest in large numbers when they believe what had been innovated is a sure thing. Uncertainty has also played a great role in any bubble that has occurred. When people believe a product is innovative or has some insight people will invest in it because of they believe that it will create economic value. Individuals who invest in this product do not know where the innovation will go although they hope it is a progressive product. The bubble typically occurs because people have a lottery mindset where they believe one can lose the money invested but if they win, the profit will be worth the risk

From this article, I believe people have the ability to avoid being pulled into a bubble if they can observe some basic behaviors. First, it is critical to avoid being overconfident when investing. Since a product is new, it is essential to do a research on what one wants to invest. It is also critical to avoid the herd mentality which makes an individual follow a group while investing.

References

Nash, A. (2013, April 20). Behavioral Finance Explains Bubbles. Retrieved from https://techcrunch.com/2013/04/20/what-can-behavioral-finance-can-teach-us-about-bubbles/