It seems nearly every financial publication released today has the term “bubble” in it somewhere. Many of us know it's a bad thing, but what does it really mean and how do they happen? Do they truly have an effect on the average consumer? Hopefully we can clear up the confusion of what an economic bubble is and determine if we can know when one is occurring.
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What Is An Economic Bubble?
Economic bubbles happen when trade of a specific item (like a stock, asset, product, or service) is artificially inflated beyond normal standards of trade. On a graph, this looks much like a bubble! The price/trade of an item might be skyrocketing higher and higher with time, but then inevitably comes crashing down in the end.
Mania, Fear, And Hysteria
Many times, economic bubbles can result from mania surrounding a product or service. Values of an item are pushed beyond normality, and everyone tries to buy the product at one time so that they might make a profit. The stock market is prime real estate for such bubbles, as it can be difficult to accurately determine the value of a stock. Because it is difficult to know whether a stock is valued too high or low, many financial advisors suggest a diversification plan when it comes to investing, and not purchasing single stocks.
A classic example of economic mania (resulting in an economic bubble) is the Dutch Tulip Mania event. Tulip bulb prices between 1636 and 1637 shot up and crashed down within months. It's said that prices were artificially inflated because everyone was buying bulbs hoping to turn around and sell them to make a profit. This is an unsustainable business model, because eventually the buying of the product outweighs the selling and the whole system comes crashing down.
A Lesson To Be Learned?
There are two schools of thought within economics when it comes to economic bubbles. Some people say that bubbles are predictable with study. Entire books have been written on how to “time” the stock market or financial future. However, mainstream economics believes that economic bubbles are both inevitable and unpredictable.
I lean towards the mainstream, and believe that bubbles can go unnoticed for a period of time before they inevitably burst and nearly everyone is surprised. The free market is a good thing and eventually equalizes the markets, but it's more of jerky roller coaster ride than smooth sailing. Not only is Wall Street affected, but Main Street as well.
The lesson to be learned? Diversify not only your investments, but also diversify your income streams. The recent recession left a countless number of people unemployed. Many only had one job before the recession hit, and now they are left with collecting unemployment.
It's All Psychological!
Contentment. It's key when you're wanting to handle your finances in a successful manner that leads to wealth. Too many get caught up in a mode of desperation and take part in the hype, mania, and overvaluing of products and services. It helps to have a calm spirit. Don't allow the media to influence your path. When everyone is saying “buy now, buy now,” it's probably not the best time to buy. Likewise, when everyone is selling, it may be unwise to sell.
Slow and steady! That's the ticket. Having a long term game plan is crucial to your success. Build a financial foundation, and slowly build wealth, one dollar at a time. Then, when the economic bubbles pop, you can sit back and relax – you've built a strong house that can weather the storm! Don't you agree?