Understanding Asset Bubbles
A Framework For Understanding Why They Occur And The Risks They Pose
(Not intended to be investment advice. Opinions are my own.)
As anyone who’s followed my work for a while knows, I am very fascinated by asset bubbles and enjoy thinking about them. Bubbles are interesting because they are more or less inevitable — people (especially investors) tend to get over-optimistic about new things or things that are performing well. That plus our tendency to herd can cause the prices of assets that the market deems attractive to rise tremendously.
I used to think that any asset whose price has significantly outgrown its underlying fundamentals (sales, earnings, etc.) was a bubble. But looking back I think I was wrong.
Liquidity and market dynamics matter too. So does leverage. It’s far easier for something illiquid like crypto to experience huge increases and declines than something like Google stock (which has a much deeper and more liquid market of buyers and sellers). Less liquid assets are much more at risk of experiencing an imbalance of buyers and sellers both on the way up (which causes the breathtaking rises) and the way down (the stomach churning declines). And if enough large investors financed their purchases with debt, then the price crash risks bleeding through to the…
