By Andrew Beattie

A bubble is a type of investing phenomenon that demonstrates the frailty of some facets of human emotion. A bubble occurs when investors put so much demand on a stock that they drive the price beyond any accurate or rational reflection of its actual worth, which should be determined by the performance of the underlying company. Like the soap bubbles a child likes to blow, investing bubbles often appear as though they will rise forever, but since they are not formed from anything substantial, they eventually pop. And when they do, the money that was invested into them dissipates into the wind.

A crash is a significant drop in the total value of a market, almost undoubtedly attributable to the popping of a bubble, creating a situation wherein the majority of investors are trying to flee the market at the same time and consequently incurring massive losses. Attempting to avoid more losses, investors during a crash are panic selling, hoping to unload their declining stocks onto other investors. This panic selling contributes to the declining market, which eventually crashes and affects everyone. Typically crashes in the stock market have been followed by a depression.

The relationship between bubbles and crashes is similar to the relationship between clouds and rain. Since you can have clouds without rain but you can't have rain without clouds, bubbles are like clouds and market crashes are like the rain. Historically, a market crash has always precipitated from a bubble (pun intended), and the thicker the clouds or the bigger the bubble, the harder it rains.

It is important to note the distinction between a crash and a correction, which can be a bit sticky at times. A correction is supposedly the market's way of slapping some sense into overly enthusiastic investors. As a general rule, a correction should not exceed a 20% loss of value in the market. Surprisingly, some crashes have been erroneously labeled as corrections, including the terrifying crash of 1987. But a "correction," however, should not be labeled as such until the steep drop has halted within a reasonable period.

Now that we're familiar with the definitions of crashes and bubbles, we can look at how they occurred throughout history

Next: Market Crashes: The Tulip and Bulb Craze »



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