What Is a Speculative Bubble?

A speculative bubble is a rapid increase in investment activity that drives prices up to very high levels. The rapid inflation of the bubble can attract more investors, creating a juggernaut as people move quickly to take advantage of the potential profits. Eventually, such bubbles burst, driving prices well below their market value before they equalize again. A number of examples have occurred around the world, illustrating a tendency for investors to create bubbles in financial markets.

Initially, a speculative bubble may develop for very sound reasons. Investors could begin buying products or shares that are likely to increase in value, such as land in a region where the government is preparing to build a road. Their purchases are in alignment with market logic, as they can expect to make a sale at a profit at some point in the future. As investment activity picks up, however, the investors may unwittingly create a bubble.

The number of buyers can increase, creating ferocious competition for products. This drives the prices up, as sellers can afford to wait for the best offer and may counteroffer if they think they can get a better deal. Fed by increasing activity, which suggests something of financial importance is occurring, investors may flock to the speculative bubble. More investors push the prices well up beyond market value, creating fragility in pricing as the prices paid skew out of alignment with reality.

While a speculative bubble may start out with logical investment activity, sometimes by very sound investors and early adopters who are quick to identify trends, it can get out of control. Investors may be driven by internal psychology more than market forces and a feeding frenzy around a given investment can occur. When the bubble bursts, prices can crash particularly hard as investors suddenly realize the value was grossly inflated. Those left holding purchases they made at high prices may take a significant loss, as prices may be unlikely to rise that high again.

Some investors can make profits from a speculative bubble. This includes not just those who buy early and sell when prices are high, but also people who utilize financial derivatives in their investment strategy. These products, like options and swaps, allow people to make bets on the direction of the market. Whether the market goes up or down, if they make sound predictions about market trends, investors can make money. Such activities can be challenging and require skill as well as nerve for the best outcome.