A Stock Market Bubble - Some Facts You Should Be Aware OfWhat is a stock market bubble? Basically, it is an economic bubble wherein the participants in the stock market drive the prices of the shares well above their fundamental values. As a general rule, the fundamental value of a certain stock is approximately equal to the present discounted value of the dividends paid on it. Think of it as the amount of money you can reasonably expect to get back if and when you choose to hold on to the stock into the distant future. The assumption is that said money is worth more today than it will be tomorrow. Also, the stock market participants assume that the economy will continue to be healthy, the profit margins will continue to grow and the consumer base will continue to expand, among other things. All of these favorable factors will supposedly lead to a higher stock price when the reality may not concur - a stock market bubble. Why does the bubble happen? Think of it this way: Investors are not willing to hold on to the stocks until a high rate of return becomes apparent, which is true when the bubble seems to have a chance of bursting - price of stocks drop significantly. When the price rises, there is an even greater chance for a loss and this, in turn, drives the prices even higher! The price continues to rise in a faster manner until such time that it falls back to its fundamental value. Many explanations have been put forth as to why these seemingly illogical things happen. One popular explanation is the behavioral finance theory wherein the stock market bubble happens because of cognitive biases in the participants. In turn, these biases lead to the so-called herd behavior where almost everybody blindly follows the market trend without questioning the validity of the movement in the first place. For example, it may be that the stock market participants idolize a certain famous person to the point of following his every move in the market. The price of the stocks then rise beyond its fundamental value, thus, the bubble. Many stock market bubbles have happened of which the most notable are the:
A stock market bubble often produces hot venues for Initial Public Offerings (IPOs). This is because the investment bankers, companies and other stakeholders in the IPOs have an opportunity to sell the new stock issues at highly inflated prices. The investment funds are then misdirected to areas with highly speculative nature instead of to enterprises that will generate long-term economic value if only funds were allocated. Unfortunately, the more IPOs are on the market, the higher the chances that many of the issuing companies are actually fraudulent. Many investors will then lose money just because they failed to investigate the stock market bubble. Indeed, jumping on the bandwagon was and is never a good thing when it comes to stock investments.
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