An asset bubble occurs when the price of a financial asset or commodity rises to levels that are well above either historical norms, the asset's intrinsic value, or both. The problem is that since the intrinsic value of an asset can have a very wide range, a bubble is often justified by the flawed assumption that an asset's intrinsic value has skyrocketed, meaning the asset is worth much more than it fundamentally is.

Some bubbles are easier to predict than others. When it comes to the stock market, traditional valuation metrics can be used to identify extreme overvaluation. For example, an equity index that is trading at a price-to-earnings ratio that is twice the historical average is likely in bubble territory, though more analysis may be needed to make a conclusive determination. Other bubbles are harder to detect, and may only be identified in hindsight.

Key Takeaways

  • A bubble occurs when the price of a financial asset or commodity rises to levels well above historical norms, above its actual value, or both.
  • When it comes to sheer size and scale, few bubbles match the dotcom bubble of the 1990s.
  • The average U.S. home lost one-third of its value when the housing bubble burst in 2009, resulting in the largest global economic contraction since the 1930s Depression, ushering in what has come to be known as the Great Recession.

Below are five of the biggest asset bubbles in history, three of which have occurred since the late 1980s.

1. The Dutch Tulip Bubble

The Tulipmania that gripped Holland in the 1630s is one of the earliest recorded instances of an irrational asset bubble. Tulip prices soared twentyfold between November 1636 and February 1637 before plunging 99% by May 1637, according to former UCLA economics professor Earl A. Thompson.

As bubbles typically do, Tulipmania consumed a wide cross-section of the Dutch population, and at its peak, some tulip bulbs commanded prices greater than the price of some houses.

2. The South Sea Bubble

The South Sea Bubble of 1720 was created by a more complex set of circumstances than Tulipmania. The South Sea Company was formed in 1711 and was promised a monopoly by the British government on all trade with the Spanish colonies of South America. Expecting a repeat of the success of the East India Company, which provided England a flourishing trade with India, investors snapped up shares of the South Sea Company.

As its directors circulated tall tales of unimaginable riches in the South Seas (present-day South America), shares of the company surged more than eightfold in 1720, from £128 in January to £1050 in June, before collapsing in subsequent months and causing a severe economic crisis.

3. Japan's Real Estate and Stock Market Bubble

In the present day, asset bubbles sometimes are fuelled by overly stimulative monetary policy. Japan's economic bubble of the 1980s is a classic example. The yen's 50% surge in the early 1980s triggered a Japanese recession in 1986, and to counter it, the government ushered in a program of monetary and fiscal stimulus.

These measures worked so well that they fostered unbridled speculation, resulting in Japanese stocks and urban land values tripling between 1985 and 1989. At the peak of the real estate bubble in 1989, the value of the Imperial Palace grounds in Tokyo was greater than that of real estate in the entire state of California. The bubble burst in 1991, setting the stage for Japan's subsequent years of price deflation and stagnant economic growth known as the Lost Decade.

4. The Dotcom Bubble

When it comes to sheer scale and size, few bubbles match the dotcom bubble of the 1990s. At that time, the increasing popularity of the Internet triggered a massive wave of speculation in "new economy" businesses. As a result, hundreds of dotcom companies achieved multi-billion dollar valuations as soon as they went public.

The NASDAQ Composite Index, home to most of these technology/dot-com company stocks, soared from a level of under 500 at the beginning of 1990 to a peak of over 5,000 in March 2000. The index crashed shortly thereafter, plunging nearly 80% by October 2002 and triggering a U.S. recession. The next time the Index reached a new high was in 2015, more than 15 years after its previous peak.

5. The U.S. Housing Bubble

Some experts believe that the bursting of the NASDAQ dot-com bubble led U.S. investors to pile into real estate due to the mistaken belief that real estate is a safer asset class. While U.S. house prices nearly doubled from 1996 to 2006, two-thirds of that increase occurred from 2002 to 2006, according to a report from the U.S.Bureau of Labor Statistics. Even as house prices were increasing at a record pace, there were mounting signs of an unsustainable frenzy—rampant mortgage fraud, condo "flipping," houses being bought by sub-prime borrowers, etc.

U.S. housing prices peaked in 2006, and then commenced a slide that resulted in the average U.S. house losing one-third of its value by 2009. The U.S. housing boom and bust, and the ripple effects it had on mortgage-backed securities, resulted in a global economic contraction that was the biggest since the 1930s Depression. This period of the late 2000s thus came to be known as the Great Recession.

The Bottom Line

Although every bubble is different, one common element in most bubbles is the willingness of participants to suspend disbelief and to steadfastly ignore the increasing number of cautionary signs. Another is that the bigger the bubble, the greater the damage it inflicts when it bursts. And perhaps most important is that the five biggest historic bubbles, along with others along the way, hold valuable lessons that should be heeded by all investors.