What is a speculative bubble?

The tulip is considered the first speculative bubble in history: it was still exotic and uncommon at the time, and it quickly developed into a status symbol, attracting the interest of merchants who speculated for increasing prices and made profits in the process. After an explosive price hike, the tulip trade came to a standstill. Increasing numbers of investors had bet on tulips and triggered a true speculation mania – a price rise of over 1,000 percent in just a few weeks was not uncommon. Finally, the grossly overvalued market collapsed. Though the example of flower bulbs may sound absurd, it is a common cycle in the world of investment: speculative bubbles emerge and burst in the same, or at least a similar way.

A more current example of a speculative bubble comes in the form of non-fungible tokens (NFTs) . After the hype’s heyday in 2021/2022, a study revealed that, in September 2023, 95 percent of NFT collections worldwide were in fact worthless. Since then, the NFT has remained active, but it is a lot smaller than it was in its heyday.

How do speculative bubbles develop?

We can explain the emergence of a speculative bubble as follows: they develop whenever a supposedly good opportunity to make money quickly occurs, and a large number of people can take advantage of this with relative ease. In these cases, many people expect the value of certain goods or assets to rise. And who wouldn’t like to benefit from that? But it’s often not that easy. As the demand for such goods or assets rises steadily, market prices will initially also rise. In most cases, the limited availability of the goods also drives the price upwards. But it very soon becomes clear that there has been an overvaluation, meaning that the prices paid are far too high. This is what is known as a speculative bubble. As investors realize this, they try to sell the goods or assets as quickly as possible. But of course there will hardly be any buyers left by that time, leading to rapid price drops, sometimes even down to zero. The bubble has now burst.

The five phases of a speculative bubble

A speculative bubble goes through five typical phases. This is something American economist Hyman P. Minsky recognized, who spent years researching how an economy goes from stability to chaos.

Displacement

The cycle of a speculative bubble begins with what’s known as “displacement”. The first investors spot a new basis for a potential economic boom, such as digitization (this was the basis of the dotcom bubble). 

Boom

More investors recognize the new pattern and invest accordingly, and prices rise. The more people invest, the sooner a boom occurs. This phase sees initial speculative purchases, often motivated by a fear of missing out. 

Euphoria

Caution in the investor community fades, and prices rise faster and more steeply. During this phase, people only buy assets if they believe someone else will pay even more for them, not because they believe in their value. This is where many people fall into psychological traps on the investor market.

Profit taking

During this phase, firstly many small-scale investors get involved. Then, the first informed investors drop out and pocket their profits. Past price peaks are either not reached anymore, or only just. In this phase of the speculative bubble, sellers still manage to find buyers, meaning there is no immediate collapse in prices. 

Panic

The mood on the market changes, usually abruptly. This is generally the result of individual pieces of information that trigger sales and cause prices to fall. As quickly as prices rise in the euphoria, they fall again, as everyone wants to sell and nobody is willing to buy. This also explains why speculative bubbles burst.

Why do speculative bubbles develop?

The exact causes of speculative bubbles aren’t entirely clear and have been subject to controversy. Possible reasons for the development of such bubbles include:

• Investors don’t act rationally but imitate the behaviour of others. This herd mentality leads to people investing because they hope to make money quickly without understanding the goods or assets.
• In behavioural economics, this principle is called “bounded rationality”. This means that people don’t always make rational decisions, because their knowledge is limited and the information they have is incomplete.
• This is where we come to the “greater fool” theory. The idea behind it is that investors are certain there will always be someone who is willing to pay an even higher price than them. They therefore expect to find an even “greater fool” to whom they can sell their goods or assets at a profit. This behaviour is primarily encountered in the euphoria phase.

And of course investors always hope that “everything will be different this time”. But even if bubbles aren’t initially easy to spot, be careful when there is a seemingly endless return potential and always keep yourself thoroughly informed. If an investment seems “too good to be true”, that is probably the case.