Countless fortunes have been made and lost during economic bubbles. Both ordinary individuals and seasoned professional investors can be caught up in a bubble’s intoxicating rise. While you might like the idea of profiting from a bubble, you’d probably like to avoid suffering from its sudden burst and long aftermath. To that end, let’s take a look at how economic bubbles work.

What Is an Economic Bubble?

An economic bubble exists when the price for an asset (or an entire class of assets) has become unreasonably high simply because so many people are buying it. Or, as an economist or financial analyst might say, a bubble has formed when an asset’s price has increased to well above its intrinsic or fundamental value. Intrinsic value or fundamental value refers to how much that asset is inherently worth, which might be equal to its market value, or, in the case of a bubble, might be less than its inflated market value. The more the asset’s owner expects to earn from holding or selling that asset, the higher its price.

Here are some examples of the intrinsic value of different assets:

These examples are a bit oversimplified, but they provide a good starting point for understanding intrinsic value. For more accurate appraisals, you’ll need to learn about discounted cash flow analysis and the net present value of future cash flows. But you don’t really need to understand all that to know how an economic bubble works. (For further reading, see How To Value A Real Estate Investment Property.)

What Causes an Economic Bubble?

Many factors can contribute to an economic bubble. Extremely high demand is one; think back to how everyone wanted to buy a house during the real estate boom. Speculation is another important contributor to creating a bubble. To go back to the real estate boom, remember your coworker who was perfectly happy renting, but decided to buy a house because she thought it would double in value in a couple of years and she could then sell it for a huge profit? Or what about the relative that already owned a house, but bought two more on the expectation of flipping for a large profit? When people think buying a certain asset will create the opportunity to make a quick fortune from either income or sale price, that expectation can contribute to a bubble.

Easy credit can also contribute to a bubble. When it’s not difficult to qualify for a loan and interest rates are low, more people can buy things that they otherwise would not be able to afford. More people in the market for an item means higher demand, which translates to higher prices. Easy credit also leads to another important contributor to bubbles: leverage, or using borrowed money to increase investment returns. That coworker who speculated on a house? She probably took out a 0 percent down mortgage to do it. When you put none of your own money at risk and are able to earn a return on it, that’s a great deal—as long as you actually make money, of course.

Innovation is also a common source of economic bubbles. People get really excited about some new thing, like the Internet, and no one knows how much the new technology is really worth. In the case of the dotcom bubble, investors bid up the prices of stocks for companies that weren’t making money, but seemed like they might make a ton of money someday. (Learn more in Market Crashes: The Dotcom Crash and 5 Successful Companies That Survived The Dotcom Bubble.) 

Financial innovation can also contribute to bubbles. We saw this with all the exotic instruments investors created during the housing bubble. Government policies that cause people to favor certain investments also play a role in creating bubbles. Examples include the mortgage interest tax deduction, which reduces the cost of home ownership for many borrowers, and government policies that encourage banks to make loans to unqualified or barely qualified buyers to meet policy goals like increasing the rate of home ownership.

What Pops an Economic Bubble?

While a bubble might seem to be based on irrational behavior or the madness of crowds—why buy something that’s priced above its fundamental value?—some economists argue that there’s nothing irrational about buying an asset whose value is expected to increase significantly and give its investor a chance to profit. After all, as the online Concise Encyclopedia of Economics says, “an asset’s fundamental value includes its expected price when sold.” 

Still, when enough investors believe that an asset is selling for much more than it’s really worth, the danger is that the bubble will pop. People will start selling the asset, and as demand rapidly decreases while supply increases, the asset’s price will fall quickly and dramatically. While on a macro level, a bubble burst can look like a good thing—the market is correcting itself and market values are realigning with intrinsic value—on the ground, long-held fortunes are being wiped out, retirement accounts evaporated and college funds lost.

Enough of these individual losses can add up to financial market turmoil, a recession and even a global financial crisis. Lots of people lose their jobs, and it becomes harder to borrow money. The pain of a burst bubble can last for months, years or even decades. Some of the most well-known bubbles in history are the Dutch tulip bulb market bubble, the South Sea Bubble, the Mississippi bubble, the Japanese real estate bubble, the Internet bubble and the housing bubble.

Predicting Bubbles

Analysts are always trying to predict the next bubble and to warn investors about bubbles before they pop. In today’s market, you’re likely to hear about three possible bubbles: a stock bubble, a higher education bubble and a second tech bubble. It’s impossible to identify a bubble with certainty until after it bursts (when hindsight is 20/20 and the writing was on the wall) but let’s consider the rationale behind the theoretical stock, college and tech bubbles.

Because student loans have such low interest rates and because the prevailing wisdom is that earning a college degree pays off handsomely over one’s career, more and more people are seeking college degrees. This demand is pushing tuition prices up at a rate that far exceeds the inflation rate or the rates of increase in the prices of other assets, like housing. At the same time, graduates are seeing lower returns on their college investments—negative returns, even, in the case of students who go into student loan debt then find themselves unemployed or underemployed. This is what Mike Fishbein, founder of the education technology company Startup College, argues in his 2014 book, Popping the Higher Education Bubble.

We’re also hearing a lot about a possible stock bubble, since the S&P 500 has returned 19.7 percent annualized since 2009. The idea here is that since bonds and cash offer such low investment returns in today’s market, and since home prices aren’t appreciating significantly and most commodity prices have been falling, people are overinvesting in stocks—particularly U.S. stocks (U.S. economic growth is higher than that of most other developed countries right now). Stocks seem like the only place to earn meaningful returns under these market conditions. Companies might not actually be generating as much value as their stock prices suggest, however; high stock prices might be largely based on a lack of good investment alternatives.

Concerns about a second tech bubble are based on the observation that technology stock prices are sky high, as are technology startup valuations.  The counterargument is that unlike the dotcom bubble, many of today's highly valued companies actually have revenue. But revenue doesn't equal profitability, and we've seen lots of unprofitable companies go public—reminiscent of the first tech bubble—and have less-than-stellar IPOs.

The Bottom Line

Investor sentiment inflates and deflates economic bubbles, and there’s no way to know for sure whether we’re rising in real value or floating 10 stories up in the middle of a bubble. When will the price of a seemingly inflated asset begin to fall? By how much, how quickly and for how long? How low will it go? The only way to avoid being affected by economic bubbles is to invest in nothing, but history has shown that even with market fluctuations, booms and busts, you’re likely to do much better by investing in bonds, stocks and real estate than by burying cans of cash in your backyard. (For further reading, see Riding The Market Bubble: Don't Try This At Home and Industries Prone To Bubbles And Why.)