What is... | February 3, 2011

What is an asset bubble?

Investors naturally want the value of their holdings to rise over time. But prices of financial assets can rise too fast and create what is known as an asset bubble.

The boom and bust of tulips, house prices and shares
History is littered with examples of investments with prices that rose very quickly and then came down with a bump. Examples include the Dutch tulip mania in the 1630s and the South Sea share bubble in the United Kingdom in the 1720s. More recently, there were house prices in Scandinavia in the early 1990s, the “dot-com” internet-related shares at the turn of this century and house prices in the United States and elsewhere ahead of the global financial crisis.

Is it inflating?
While it is possible to identify an asset bubble in hindsight after it has burst, it can be harder to identify one as it happens. Typical warning signs include prices changing very rapidly – with the rises straying from previously accepted notions of value for that particular asset. It might be that lending for these assets is available with much lower collateral than in the past, fuelling the rise. There is discussion at the moment about whether a bubble is building for property in China and other parts of Asia with booming prices and government intervention to tighten lending.

One person’s bubble
One person’s asset bubble might be another person’s excellent investment opportunity. A person who buys an investment when prices are rising and sells before they fall can make a large profit. But those who still own the investment when price collapses stand to make large losses, especially if they have borrowed to fund their purchase. One of the characteristics of asset bubbles is the very rapid falls in price when they burst. Buyers typically desert the market. In the parlance of financial markets, liquidity (the ease of buying and selling) dries up. There is disagreement about whether it is possible to identify a bubble before it bursts and, if so, whether the authorities should act to deflate them. An entry in the Financial Times’ Money Supply blog last year highlighted opposing views from two members of the US Federal Reserve’s policy committee.

Housing bubbles
Housing is particularly prone to bubbles. Rising property prices might encourage people to believe prices will continue to rise and aspiring homeowners can worry they will miss out if they don’t buy soon. The 2009 influential book This Time Is Different detailed financial crises going back hundreds of years. A key finding was that booms and busts in property prices have been associated with most financial crises over the centuries. Figures show real house prices in the United States rising 92% between 1996 and 2006 – an increase in a decade of more than three times that seen over the previous century.

Why bubbles burst
Just as anything thrown up into the air must come back to earth, economists believe all prices eventually return to their true value. There can be many triggers behind an asset bubble burst. Wider economic factors might contribute (such as a rise in interest rates pushing up the cost of borrowing used to fuel a bubble). Or people can simply decide prices are too high, stop buying and the market reacts.

Don’t blow it
Homebuyers and investors should try to avoid being caught up in a bubble by considering their attitude to risk and how they would react if they lost money in an investment. It can be dangerous to buy something just because the price is rising – property included. Always remember that house prices can fall, as ING Group chief economist Mark Cliffe’s second video lesson from the financial crisis explains. Make some basic calculations to consider whether a property is worth the price, such as the house price to wage ratio detailed in this eZonomics video. For a wide range of investments, it can pay to organise finances to cover emergencies and other financial essentials before putting money into more risky products. The eZonomics video The share market has risen. Is it too late to dive in? outlines this idea as well as the theories surrounding the importance of diversification.

From the ashes
For all of the trouble that asset bubbles bring, they can be blessing in disguise. Some argue that large swings in asset prices are part of the way economies experiment in finding new technologies. Massive investment in new railway lines in the 1840s and in telecommunications equipment in the 1990s left behind assets that still widely used today – although their value is now considered much lower than at the peak of their popularity.

InvestingHouse buyingHouse pricesBubble

Phil Thornton
Phil Thornton

Lead consultant at Clariti Economics