3 Things to Know About Economic Bubbles if You Want to Make Money

When investors become illogical, you may have the makings of an economic bubble.

When a particular asset is valued significantly higher than its actual worth, it's known as a "bubble." And to be clear, economic bubbles burst. At some point, it's as though everyone admits, "Yeah, we knew that was overvalued."

1. Bubbles are nothing new

As long as there's been money to be made, there have been economic bubbles. There are plenty of historical examples. Here are two of them.

Tulipmania (1634–1638)

The Dutch are known for their love of tulips and have poured their hearts and souls into developing the many different varieties. At first, it was wealthy Europeans who became tulip enthusiasts. By the mid-1630s, the tulip craze caught fire, and even middle-class and poor families wanted the bulbs to plant.

With so many people vying for bulbs, the tulip market went wild, reaching its peak in 1636. Now, this is where things get interesting. As the price of tulips increased, people started thinking, "Hey, if I can get my hands on bulbs at a fair price, I can resell them at a higher price and become rich."

People mortgaged their homes and businesses just to buy bulbs for resale. And what they were willing to pay for a single Viceroy tulip bulb got out of hand. So many people bought into the myth that tulips were worth a king's ransom that when the bubble finally burst, the Netherlands was plunged into an economic depression.

Takeaway: Just because others say an asset is hot doesn't mean it will be a moneymaker.

Dot Com Bubble (1990s)

A bubble that may be more familiar to contemporary readers is the internet or dot com bubble of the 1990s. As the internet became available in consumers' homes and the tech industry appeared ready to take over the world, investors wanted in on the action.

The more people invested money in dot com stocks, the more others developed FOMO (fear of missing out). Pretty soon, people who had no interest in tech were throwing all the money they could find into the industry. On Nasdaq, tech values soared, and many were convinced they'd invested in the right thing.

Soon, stocks were selling for far more than they were actually worth, and when the bubble burst and stock values crashed, millions lost money.

Takeaway: Economic bubbles have risen and burst time and time again. Because we know that it's possible for any asset to become overvalued, it's up to us to use our common sense when the rest of the world appears to be going mad.

2. There are four stages

The investors who make money in an economic bubble are those who get in early and then sell before the bubble bursts. Unfortunately, it's impossible to accurately time the market. However, understanding that the typical bubble consists of four stages can give you a sense of when it's time to see yourself to the door.

Stage one: Stealth phase

A small number of people see promise in a new investment opportunity.

Stage two: Awareness phase

More people want in, and prices increase. The media catches on and the investment gains further exposure.

Stage three: Mania phase

Prices continue to climb, the hype grows, and the potential for easy money appears limitless. Investors become irrational, willing to pay anything to get in on the "sure thing."

Stage four: Blow-off phase

There's a cooling of sorts. Suddenly, people begin to admit that prices have gotten out of hand and that the asset has an unrealistic value. The media reports become negative. Buyers lose interest, the bubble bursts, and prices plummet.

Takeaway: Avoid the rush to buy during the mania phase. You're likely to overpay.

3. There's still a chance to make money

Overly enthusiastic investors explain why bubbles are formed. However, what goes up must come down, and that's where a smart investor picks up the best deals. Once buyers lose interest and investors sell off, you're likely to find bargain basement prices.

Let's say the bubble that burst was in the housing market. Prices drop, and you realize = you could snag a fair deal on a property to rent out or flip. A bubble bursting doesn't necessarily mean that the asset was a stinker. It just means that people allowed their emotions (and greed) to drive their decision making for a time.

Takeaway: Once a bubble has burst, examine the asset from every direction to determine whether it's a good investment at the new, lower price.

Few things in life are all bad or all good, and the same is true of economic bubbles. Knowing how to avoid the mania and capture a bargain basement price on your investments is your superpower.