This post was originally published on this site

Editorial Note: Forbes may earn a commission on sales made from partner links on this page, but that doesn’t affect our editors’ opinions or evaluations.

A stock market bubble—also known as an asset bubble or a speculative bubble—is when prices for a stock or an asset rise exponentially over a period of time, well in excess of its intrinsic value. Eventually, prices hit a wall and then fall very far, very fast, as the bubble “pops.” Bubbles can occur to all kinds of assets in addition to stocks, from real estate and collectibles, to commodities and cryptocurrencies.

How Does a Stock Market Bubble Happen?

A stock market bubble is driven by raw speculation. A bubble begins to form when there’s a gathering acceleration in price for an asset that far outstrips the asset’s intrinsic value. That means people are willing to pay more and more for a security or another asset, above and beyond what’s expected based on things like demand, earnings, revenue or growth potential.

Irrational exuberance is a phrase popularized by former Federal Reserve Chair Alan Greenspan to describe the collective enthusiasm among traders and investors that fuels rapidly increasing prices that outstrip underlying fundamentals. Whether you call it the crowd mentality, herd bias, the bandwagon effect or FOMO, there is a self-perpetuating cycle where people want to buy an asset because its price is increasing, driving the price even higher and making even more people want to buy it.

It’s important to note that not all periods of rapid price acceleration are bubbles. For example, following a recession or bear market, it’s normal for asset prices to recover sharply. While hope and speculation may also fuel that rebound—namely, that the worst of market declines or an economic slowdown are over—the key difference is that these price increases can ultimately be justified by fundamentals.

Stages of a Bubble

Stock market bubbles generally follow the same five stages, first identified by American economist Hyman Minsky:

Displacement

In the first stage of a bubble, a big change or a series of changes affects how investors think about markets. This paradigm shift could include a significant event or an innovation that causes people to—with good intentions—change their expectations for the asset in question.

Boom

The displacement stage results in some price increase, but things really speed up during the second stage of a bubble. The boom phase attracts speculators who help drive the price of the asset higher as word spreads about its gains.

Euphoria

Fervor intensifies as the asset’s price skyrockets. During the peak euphoria stage, people are driven more by excitement than rational justification for the huge surge in prices. And because new participants are eager to buy in, there’s a sense there will always be someone who’s willing to pay more for the asset.

This can make it feel like there’s no risk you’ll lose money no matter when you buy in. During euphoria, investors have thrown all caution to the wind in pursuit of what seems like a too-good-to-be-true way to get rich quickly.

Profit Taking

Inevitably, the surge in prices ends up being too good to be true. Booms are followed by busts, and some people begin selling off to lock in gains as the bubble enters the profit taking stage. The bubble has been pricked, and those investors who recognize those signs will reap their profits early.

Panic

While some late-to-the-game speculators may have held out previously—in hopes that an asset’s price might go back up—by the time the bubble reaches its panic stage, that’s no longer tenable. Instead, the fervor to buy an asset has been replaced by a panic to sell. The plunge in prices quickly wipes out profits and encourages more panic-induced selling.

Examples of Economic Bubbles

People often refer to any rapid increase in prices as a possible bubble, but these events are actually more uncommon than you may realize. Famous bubbles include:

  • Tulipmania. The bubble to which all other bubbles are compared, tulipmania struck Holland in the 1630s as the price of Dutch tulips rapidly surged, far beyond their worth. Tulip prices crashed only a few months later, with the flowers eventually selling for a fraction of their peak prices.
  • South Sea Company. Amid speculation about the potential profits from a trade monopoly in the 1720s, the South Sea Company’s stock price surged in a matter of months, only to crash, resulting in an economic downturn.
  • Dot-com bubble. The late 1990s saw many Internet-focused companies filing for initial public offerings (IPOs). The then-new and rapidly expanding internet industry was a paradigm shift, and many investors were eager to invest—even in shares of companies that didn’t prove to have sustainable business models, like Pets.com, which liquidated less than one year going public. Some people even took to day trading as a full-time job, and the broader S&P 500 more than doubled in value in a matter of years. But as some individual companies collapsed, that led to a broader crash in the stock market.
  • The U.S. housing bubble. By the mid-2000s, a bubble began to form in the U.S. housing market amid a very rapid acceleration in home prices. Speculators began to flip homes, in hopes of making a profit, and the average price of a U.S. home increased almost 80% between 2000 and 2006. But people who couldn’t afford homes were buying, and the bubble eventually burst. It took about 10 years for housing prices to fully recover.

What Causes an Asset Bubble?

The initial stages of a bubble may be benign. For example, a Wall Street analyst might upgrade their recommendation of a stock, and that catches attention among investors who then become more bullish. Similarly, rumors, a prominent investor, news reports, or information shared online or on social media could also spark speculative fervor.

What Makes an Asset Bubble Pop?

An asset bubble pops when there’s a drastic change in expectations. For example, a prominent market participant could cause excitement to sour. Or the bubble could burst as a result of selling activity that makes investors nervous, causing a panic that results in people selling the asset as quickly as possible—and further price declines.

While market participants may try to curb both the sudden surge and decline in prices during a bubble, there’s not much they can do other than urge caution. During large drops or periods of intense volatility, the U.S. Securities and Exchange Commission (SEC) has a mechanism in place to prohibit trading activity in individual assets to try and give the market a chance to cool down.

How to Recognize an Economic Bubble

It’s tempting to classify something as a bubble when the price is skyrocketing, but it’s actually hard to categorize something as a bubble until it’s popped. Not all speculative activity that spurs price increases in the first place results in a change in expectation that causes the price to plummet.

Even so, it’s possible to recognize signs of a bubble when an asset’s price rises above and beyond its fundamental value. By identifying behavior that aligns with the early stages of a bubble, it may be possible to recognize an economic bubble while it’s happening, though it’s impossible to know if and when prices will eventually fall.

How to Invest During a Stock Market Bubble

Because bubbles are inherently driven by speculative behavior, the associated activity falls more within the realm of day trading rather than long-term investing. Even so, you may be swept up in a bubble without intending to do so. For example, the housing bubble of the mid-2000s affected homeowners of all types—those people who bought or sold when prices were going up as well as those who held onto their homes as the bubble ran its course.

To avoid the inherent risk of participating in a bubble that eventually bursts, it’s important to carefully consider your reasons for investing before you do so. If you are chasing returns out of some feeling of FOMO or to hop on a bandwagon, then your expectations for returns are likely driven more by speculation than an asset’s fundamental value, which can come back to bite you if, or when, a bubble bursts.

That’s why experts recommend most investors buy into a diversified mix of low-cost index funds to minimize the risk that any one investment falters while positioning themselves for long-term growth. It may not have the highs of the stratospheric ride of asset bubble investments, but it also doesn’t usually have the extreme lows either.