The company had no problem attracting investors desperate for a place to put their money. People rushed to purchase shares so they wouldn’t be left out, scraping together whatever money they could, seeing only boundless opportunities for gain.

Excitement and tension increased in the same proportion as the increase in stock prices. Plans were made for spending their newly acquired wealth.

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Then, share prices started falling. People started panicking and sold their shares – many lost everything.

Does this sound familiar? It shouldn’t (except in a history lesson) because it happened in 1719-1720 and is known as the South Sea Bubble.

Tulipomania

Another famous bubble was the tulip bulb frenzy in the 1630’s. The novelty of tulips made them widely sought after and, therefore, pricey. The increased scarcity and demand drove prices up so fast and so high that one-month showed a twenty-fold increase.

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At the peak people were trading their estates and life savings for one tulip bulb.

Why is it called a bubble?

A bubble occurs when investors put so much demand on an investment that they drive the price up beyond any rational reflection of its actual worth.

It often appears as though the investment will rise forever.

Compare this effect to Bazooka bubble gum. People of a certain age will remember this appalling, latex-textured gum with its enclosed corny Bazooka Joe comic.

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The gum could be blown into a fair sized bubble. The larger the bubble, the thinner it got, which meant it started getting bigger and bigger – until it exploded all over your face and got stuck in your hair and eyebrows.

Investment bubbles follow the same process: a period of reasonable growth then a remarkable rise that accelerates even further. Prices climb so rapidly that what should make them obviously ridiculous becomes perversely attractive instead.

Near the end of every bubble more investors feel compelled to join in – causing the process to gather speed, until its inevitable implosion.

Modern day bubbles

High-tech bubble: Who can forget the “dot-com” craze? Computers and their technology were the latest thing, and investors wanted big, new ideas and advancements more than a solid business plan.

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In 1999 there were 457 IPOs issued, most of which were internet and technology related. Of these IPOs, 117 doubled in price the first day of trading. When the bubble collapsed the Nasdaq lost 78% of its value.

Housing bubble: House prices were soaring and interest rates were low, leading to real estate speculation and questionable lending practices as consumers viewed their homes as a “piggy bank” that they could extract cash from.

Mortgages were re-packaged and turned into AAA-rated securities (exceptional degree of creditworthiness according to Standard & Poor) and sold to investors who were seeking higher returns as well as to pension funds and mutual funds around the world.

Prices on these mortgage-backed securities eventually plummeted, prompting large losses for banks and other financial institutions and shares fell hard. Consumers lost big time when house values and retirement funds plunged in value.

What’s next?

Will we be facing another stock market bubble? From tulip bulbs to gold, if there’s lots of money to be made we want to be in on the rush.

Will it be in commodities, as emerging countries begin their own industrial revolutions?

Will there be another high-tech bubble? The highly anticipated Facebook IPO was the biggest in technology history even with the claims that the initial price was too high and not supported by potential revenue.

People were chewing their fingers when the Nasdaq had some technical glitches and orders couldn’t be filled.

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Apple shares had a record high of over $700 in September of last year. The price has since dropped but is still almost double the previous high in December 2007 ($199).

The Dow Jones Industrial Index is also reaching record highs on increased US corporate profits (even though many large corporations received free money from the Federal Reserve).

What can we learn?

For future investment success we should learn positive lessons from bubbles – such as the importance of diversification and independent research and staying with your planned asset allocation.

The unreasonable belief in the possibility of getting rich quick is the primary reason that people get burned.

Big leaps in share prices should be justified by the future prospects of the underlying companies.

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Keep yourself informed and keep your emotions in check.

(Source on market bubbles: Investopedia)