A stock market bubble is a type of economic bubble taking place in stock markets when price of stocks rise and become overvalued by any measure of stock valuation. An economic bubble (sometimes referred to as a speculative bubble, a market bubble, a price bubble, a financial bubble, or a speculative A stock market, or (equity market is a private or public market for the trading of company Stock and derivatives of company Software for Fixed assets management and Stock control developed in 2004.

The existence of stock market bubbles is at odds with the assumptions of efficient market theory which assumes rational investor behaviour. Behavioral finance theory attribute stock market bubbles to cognitive biases that lead to groupthink and herd behavior. Behavioral economics and behavioral finance are closely related fields which apply scientific research on human and social cognitive and emotional factors to better A Cognitive bias is a pattern of deviation in judgement that occurs in particular situations (see also Cognitive distortion and the Lists of thinking-related topics Groupthink is a type of thought exhibited by group members who try to minimize conflict and reach consensus without critically testing analyzing and evaluating ideas Herd behaviour describes how individuals in a group can act together without planned direction Bubbles occur not only in real-world markets, with their inherent uncertainty and noise, but also in highly predictable experimental markets ^[1]. In the laboratory, uncertainty is eliminated and calculating the expected returns should be a simple mathematical exercise, because participants are endowed with assets that are defined to have a finite lifespan and a known probability distribution of dividends. Other theoretical explanations of stock market bubbles have suggested that they are rational ^[2], intrinsic ^[3], and contagious ^[4].

Examples

The NASDAQ Composite index spiked in the late 90s and then fell sharply as a result of the dot-com bubble. The Nasdaq Composite is a Stock market index of all of the Common stocks and similar securities (e The " dot-com bubble " (or sometimes the " IT bubble " was a speculative bubble covering roughly 1995–2001 (with a climax on March 10

Two famous early stock market bubbles were the Mississippi Scheme in France and the South Sea bubble in England. In August 1717 Scottish businessman John Law acquired a controlling interest in the then derelict Mississippi Company and renamed it the Compagnie d'Occident (or Compagnie For the Noel Coward play see South Sea Bubble (play. The South Sea Bubble of 1720 was an Economic bubble that occurred England is a Country which is part of the United Kingdom. Its inhabitants account for more than 83% of the total UK population whilst its mainland Both bubbles came to an abrupt end in 1720 bankrupting thousands of unfortunate investors. Those stories, and many others, are recounted in Charles Mackay's 1841 popular account, "Extraordinary Popular Delusions and the Madness of Crowds. Charles Mackay (27 March 1814 &ndash 24 December 1889 was a Scottish poet journalist and song writer Extraordinary Popular Delusions and the Madness of Crowds is a popular history of popular folly by Charles Mackay, first published in 1841. "

The two most famous bubbles of the twentieth century, the bubble in American stocks in the 1920s and the Dot-com bubble of the late 1990s were based on speculative activity surrounding the development of new technologies. The " dot-com bubble " (or sometimes the " IT bubble " was a speculative bubble covering roughly 1995–2001 (with a climax on March 10 The 1920s saw the widespread introduction of an amazing range of technological innovations including radio, automobiles, aviation and the deployment of electrical power grids. The 1990s was the decade when Internet and e-commerce technologies emerged.

Other stock market bubbles of note include the Nifty Fifty stocks in the early 1970s, Taiwanese stocks in 1987 and Japanese stocks in the late 1980s. Taiwan has a dynamic capitalist economy with gradually decreasing guidance of investment and foreign trade by the Republic of China (ROC government which

Stock market bubbles frequently produce hot markets in Initial Public Offerings, since investment bankers and their clients see opportunities to float new stock issues at inflated prices. Initial public offering (IPO, also referred to simply as a "public offering" is when a company issues Common stock or shares to the public for the first These hot IPO markets misallocate investment funds to areas dictated by speculative trends, rather than to enterprises generating longstanding economic value.

A rational or irrational phenomenon?

Emotional and cognitive biases (see behavioral finance) seem to be the causes of bubbles. Behavioral economics and behavioral finance are closely related fields which apply scientific research on human and social cognitive and emotional factors to better But, often, when the phenomenon appears, pundits try to find a rationale, so as not to be against the crowd. Thus, sometimes, people will dismiss concerns about overpriced markets by citing a new economy where the old stock valuation rules may no longer apply. The New Economy was an evolution of developed countries from an industrial/manufacturing-based wealth producing economy into a Service sector Asset based economy This type of thinking helps to further propagate the bubble whereby everyone is investing with the intent of finding a greater fool. Still, some analysts cite the wisdom of crowds and say that price movements really do reflect rational expectations of fundamental returns. Rational expectations is an assumption used in many contemporary macroeconomic models, and also in other areas of contemporary Economics and Game theory

To sort out the competing claims between behavioral finance and efficient markets theorists, observers need to find bubbles that occur when a readily-available measure of fundamental value is also observable. The bubble in closed-end country funds in the late 1980s is instructive here, as are the bubbles that occur in experimental asset markets. For closed-end country funds, observers can compare the stock prices to the net asset value per share (the net value of the fund's total holdings divided by the number of shares outstanding). For experimental asset markets, observers can compare the stock prices to the expected returns from holding the stock (which the experimenter determines and communicates to the traders).

In both instances, closed-end country funds and experimental markets, stock prices clearly diverge from fundamental values. Nobel laureate Dr. Vernon Smith has illustrated the closed-end country fund phenomenon with a chart showing prices and net asset values of the Spain Fund in 1989 and 1990 in his work on price bubbles. Vernon Lomax Smith (born January 1, 1927) is professor of Economics at Chapman University School of Law and School of Business in Orange At its peak, the Spain Fund traded near $35, nearly triple its Net Asset Value of about $12 per share. At the same time the Spain Fund and other closed-end country funds were trading at very substantial premiums, the number of closed-end country funds available exploded thanks to many issuers creating new country funds and selling the IPOs at high premiums.

It only took a few months for the premiums in closed-end country funds to fade back to the more typical discounts at which closed-end funds trade. Those who had bought them at premiums had run out of "greater fools". For a while, though, the supply of "greater fools" had been outstanding.

Stock market bubble as an example of positive feedback

A rising price on any share will attract the attention of investors. Positive feedback, sometimes referred to as "cumulative causation" is a Feedback loop system in which the system responds to perturbation in the same direction Not all of those investors are willing or interested in studying the intrinsics of the share and for such people the rising price itself is reason enough to invest.

In turn, the additional investment will provide buoyancy to the price, thus completing the loop.

Like all dynamical systems, financial markets operate in an ever changing equilibrium, which translates into price volatility. However instable is this balance, a self-adjustment (negative feedback) takes place normally: when prices rise more people are encouraged to sell, while fewer are encouraged to buy. Negative Feedback feeds part of a System 's output inverted into the system's input generally with the result that fluctuations are attenuated This puts a limit on volatility. However, once a positive feedback takes over, the market, like all systems with positive feedback, enter a state of increasing disequilibrium. In Economics, economic equilibrium is simply a state of the world where economic forces are balanced and in the absence of external influences the (equilibrium values of economic This can be seen in financial bubbles where asset prices rapidly spike upwards far beyond what could be considered the rational "economic value", only to fall rapidly afterwards.

References

See also

• Business cycle
• Collective behavior
• Fictitious capital
• Market trends
• Modeling and analysis of financial markets
• Mississippi Company
• Poseidon bubble
• Pyramid scheme
• Railway Mania
• The South Sea Company
• Tulip mania
• Dot-com bubble
• Diversification

External links

• Accounts of the South Sea Bubble, John Law and the Mississippi Company can be found in Charles Mackay's classic Extraordinary Popular Delusions and the Madness of Crowds (1843) - available from Project Gutenberg. The term business cycle or economic cycle refers to the fluctuations of economic activity during its long term growth trend The term " collective behavior " was first used by Robert E Fictitious capital is a concept used by Karl Marx in his critique of Political economy. In Investing, Financial markets are commonly believed to have market trends that can be classified as primary trends secondary trends (short-term and secular trends Much effort has gone into the study of financial markets and how prices vary with time In August 1717 Scottish businessman John Law acquired a controlling interest in the then derelict Mississippi Company and renamed it the Compagnie d'Occident (or Compagnie The Poseidon bubble was a Stock market bubble in which the price of Australian Mining shares soared in late 1969 then crashed in early 1970 A pyramid scheme is a Non-sustainable Business model that involves the exchange of Money primarily for enrolling other people into the scheme without Railway Mania is the term given to the speculative frenzy in Britain in the 1840s For the Noel Coward play see South Sea Bubble (play. The South Sea Bubble of 1720 was an Economic bubble that occurred Tulip mania or tulipomania ( Dutch names include tulpenmanie tulpomanie tulpenwoede tulpengekte and bollengekte) was a period in the The " dot-com bubble " (or sometimes the " IT bubble " was a speculative bubble covering roughly 1995–2001 (with a climax on March 10 Diversification in Finance is a Risk management technique related to hedging, that mixes a wide variety of investments within a portfolio. For the Noel Coward play see South Sea Bubble (play. The South Sea Bubble of 1720 was an Economic bubble that occurred John Law (usually pronounced Jean Lass by contemporary French ( bap In August 1717 Scottish businessman John Law acquired a controlling interest in the then derelict Mississippi Company and renamed it the Compagnie d'Occident (or Compagnie Charles Mackay (27 March 1814 &ndash 24 December 1889 was a Scottish poet journalist and song writer Extraordinary Popular Delusions and the Madness of Crowds is a popular history of popular folly by Charles Mackay, first published in 1841.
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