History has shown that asset bubbles regularly occur in share markets, real estate, commodities, precious metals and even in the flower market. A bubble is formed when excessive speculation enters a market and the speculators drive prices to an irrationally high level. At such times, decisions are made based on the “greater fool theory of investing”. That is, it doesn’t matter that a price is overvalued; it only matters that it can be sold for an even greater price to someone else.  Bubbles often end with steep declines in the price of the asset.

History teaches that it pays to be aware of when an asset bubble is forming and to tread carefully rather than be swept up in the hype that surrounds these bubbles.

1635: The Tulip and Bulb Craze

Late in the 16^thcentury, middle – class Dutch society came to applaud the beauty of the flower from the then-rare tulip root. By 1635, one quality tulip could be exchanged for an entire estate. Labourers, seamen and chimney sweeps joined the frenzy and overseas capital was directed at the market.

The bubble burst when prudent investors decided to sell and crystallize their gain and buyers defaulted on purchase agreements and people lost interest in the flower. By 1636, tulip markets confidence had been shattered and panic spread across Holland. Neither the courts nor the government could stop widespread bankruptcies. At the bottom of the market you could exchange one tulip for an onion.

1987 – The Crash of 1987

In October 1987 share markets all over the world fell dramatically with the US share market (Dow Jones Industrial Average Index) experiencing its largest one day fall in its history, declining by 22.6% on ‘Black Monday’ (19^thOctober). In the remaining days to the end of October the Australian share market fell by 41.8%. Prior to this fall, the US share market had experienced two consecutive years of gains exceeding 20%.

Unlike many other share market crashes, no single event can account for the crash. Possible causes often cited include that the share market had reached excessive valuation levels and a new trend that saw share investors switch to fixed interest investments that offered high interest rates. At this time, interest rates from fixed interest investments in the US climbed above 10%.

As the momentum of selling picked up, the ability to sell shares readily at a reasonable price dried up and buyers waited for further falls. Share holders panicked and began selling at any price and this further drove down share prices.

2000 – DotCom

The DotCom period grew originally from the increased usage of the internet and was often referred to as the new economy. The companies within the new economy were directly involved in making hardware (computers, mobile telephones, fibre optic cable etc) or software, doing something new and amazing on the internet, or producing content for the net to carry. The share prices of these new economy companies increased significantly and in some cases sky rocketed to high levels.

The bursting of the DotCom bubble resulted in the US share market index – NASDAQ falling 78% from its peak to the bottom.

The fall was triggered by many new economy businesses posting huge financial losses and failing to meet their revenue targets. Investors also became concerned about the high valuations of these companies. At the same time, the economies of developed countries began to slow and investors turned to more traditional and ‘old economy’ companies like banks, resources and diversified industrial companies.

2008 – The Global Financial Crisis

The Global Financial Crisis is considered by many investment specialists and commentators to be the worst financial crisis since the Great Depression of the 1930’s.

A bubble developed as higher prices for houses in the United States was fuelled by low interest rates and people borrowing money to buy houses even though they couldn’t afford the repayments. Financial institutions lending money to home owners were relying on continued increases in house prices and low interest rates on the borrowings.

The development of financial instruments such as Mortgage Back Securities (MBS) and Collateral Debt Obligations (CDOs) which derive their value from US house prices exacerbated the bubble in the housing market.

The US housing bubble burst in part because of an increase in interest rates which made it harder for a large number of borrowers to repay their loan. This resulted in many borrowers foreclosing and defaulting on their housing loans which caused a substantial fall in US house prices.

In turn, this led to substantial falls in the value of financial instruments such as MBS and CDOs linked to the US housing market resulting in financial institutions losing over US$2.8 trillion dollars.

Financial institutions stopped lending (even to each other) and there was a drop in the level of confidence in the financial system which developed into a credit crisis.  A spill over into the US economy caused household wealth in the US to fall by 20%. There was a decline in the confidence of US consumers and businesses and in turn, mass redundancies.  The ramifications of these developments were felt all over the world by most financial institutions, investors and governments.

Share markets globally collapsed as the full extent of the losses by financial institutions were revealed and the reverberations on the US and other economies were felt.

Globally governments reacted by announcing huge spending programmes and financial support to mostly financial and other major affected companies and central banks aggressively reduced their official interest rates to help shield their economies from the fall out.