Bubble Theory

DEFINITION of 'Bubble Theory'

A school of thought that believes that the prices of assets can temporarily rise far above their true values and that these bubbles are easily identifiable. Former Federal Reserve Chairman Alan Greenspan famously coined the term "irrational exuberance" referring to asset bubbles. Under the bubble theory, large overvaluations of assets can persist for many years, but eventually burst, causing precipitous declines before returning to more reasonable prices.

BREAKING DOWN 'Bubble Theory'

One of the most famous historical examples of an asset bubble is the so-called "tulipmania" in the Netherlands during the 1630s. Contemporary examples include the dotcom bubble in the late 1990s, and the real estate bubble in the U.S. in the late 2000s.

The bubble theory is controversial among those who believe in the theory of efficient markets. Efficient market theorists believe that market participants are rational, and therefore would not buy into asset bubbles if they were readily identifiable. Rather, these theorists argue, clear overvaluations would be driven down to their true value by savvy market participants who would sell the asset, anticipating a decline to the true value.