How To Identify A Market Bubble

While explaining the term market bubble’, this article by Vaishnavi Chauhan elucidates how by prioritising fundamentals, maintaining a long-term perspective and resisting emotional impulses, investors can navigate market bubbles more effectively and safeguard their portfolios against unnecessary risks

- Vaishnavi Chauhan

The term 'market bubble' has been making rounds on Dalal Street for a while. Let's understand what it means and how it actually works. A stock market bubble refers to a situation where stock prices are driven to high levels by speculative buying, often far exceeding the intrinsic value of the underlying assets. During a bubble, investors buy stocks based on the expectation that prices will continue to rise, rather than on the fundamental value of the companies. This can lead to unsustainable price increases, fuelled by excessive optimism and speculation. Eventually, the bubble bursts when investors realise that the stock prices are not justified by economic fundamentals, leading to sharp declines in prices and significant market corrections.

South Sea Bubble

Taking a tour back in time. During the early 1720s, Europe experienced the South Sea Bubble, a financial phase revolving around the South Sea Company, which held exclusive trade rights to South America. Promising vast riches from this trade, the company's stock price soared, fuelled by speculation and media hype. Even Sir Isaac Newton, renowned physicist and mathematician, was drawn into the allure of quick wealth. Initially, Newton invested wisely and profited.

However, enticed by the escalating gains, he poured a substantial portion of his wealth, possibly up to £20,000, into the company. And, like all bubbles, the South Sea Bubble eventually burst in 1720, resulting in significant losses for many, including Newton. Legend suggests that Newton, upon realising his mistake, lamented, "I can calculate the movement of the stars, but not the madness of men." While the historical accuracy of this quote is debated, it encapsulates the essence of the situation.