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What is a Stock Market Bubble?

Updated on February 27, 2012

Herding Behavior

"Recency Bias"
"Recency Bias"

Fundamental Catalysts:

Bubbles don’t exist randomly. They will always develop over time based on strong (and legitimate) underlying fundamental data. Bubbles form with good economic reasoning behind them. This fuels the “it’s different this time” mentality, and helps rationalize the bubble’s existence.

Herding Behavior Builds:

As the tendency to overweight recent events and ignore historical facts increases (termed “recency bias”) the system begins to naturally develop a ponzi process as more and more investors get in on “the next big rally”. Media fuels the trend up, along with those with a vested interest in the specific market, those who “bail” after incorrectly betting against the trend, etc.

The Illusion of Stability:

Investor confidence soars, as the illusion of control increases. Trades become bigger, price targets get raised, etc. All of which are a byproduct of the first two characteristics above. Investors can more easily convince themselves that it really is “different this time”. All of this is occurring while the system grows increasingly unstable.

"It's Different This Time"

Eventual Systemic Collapse
Eventual Systemic Collapse

Eventual Systemic Collapse:

The bubble collapse begins. To the surprise of the investors, it’s not actually “different this time”. As the herding effect begins to break down, there is a panic flee to the exits, as the herd reverses course. The party is over. Collapse ensues. The bubble deflates.

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