Philosopher George Santayana purportedly said, “Those who cannot remember the past are condemned to repeat it.” While this quote resonates with me in many areas of life, it reminds me most of human behavior in times of economic bubbles. This is a discussion of economic bubbles, what you can learn from their history, and how you can stay on track financially during a bubble burst.

Understanding Bubbles

An economic bubble is defined by a rapid increase in market value above the inflation-adjusted value, oftentimes specifically referring to the price of an asset. Let’s go with a simple example. If the price of wood increased 500% in one year but all other building materials like stone, metal, and concrete increased in line with inflation, market reactions may differ a bit.

Some people might think wood is a great investment and buy more of it, expecting the price to continue to rise. The price could then indeed rise more rapidly. New businesses may flood the market with the goal of chopping down trees to gain more wood and demand for machines used to do this job may increase as well. The cost of building new constructions using wood may rise, and homes built using other materials could experience a decrease in resale value.

Now I ask you: what is most likely to happen then? Many could stand to profit, and many may experience financial pain in the short run. Eventually, that rapid price increase would likely fall back in line with historical prices. In that case, the people who stockpiled the wood until this time would take investment losses, many of the businesses would fail, many of the machines would fall into disuse, and cost of construction would normalize.

Some Bubble History

You may think from my example, “who on earth would fall for a wood bubble?” Well, you may be surprised to learn that the first recorded speculative bubble in history was over flowers.

Tulip Mania

Tulip Mania started in the Netherlands in 1634 and tulip bulbs became so coveted by the rich and powerful that fortunes could be made overnight on particularly rare bulbs. In 1637, the bubble abruptly burst, leaving people in the trade with nearly worthless bulbs.

The Roaring Twenties

1924-1929 was a time of surplus in the United States. Economic policies following the end of World War I included free trade, anti-inflation measures, expansion of consumer credit, debt financing for businesses and relaxation of anti-trust laws. Businesses thrived and the stock market gained a huge following, with stock prices rising far beyond what the economy could sustain. The bubble burst and it ushered in the Great Depression, which was the worst economic disaster in American history.

The Dot-Com Bubble

In the 1990s, Americans became fascinated with the internet and technology companies. The stock of any company ending in dot-com was seen as a golden investment opportunity, and money poured into companies from speculative investors and venture capital. Many of these companies lacked a significant product and failed to generate profits. In 2001, the bubble burst and many companies previously worth millions on paper were suddenly worthless.

The U.S. Housing Bubble

The U.S. housing bubble in the mid-2000s is largely attributed to an incline in housing prices following the dot-com bubble burst bolstered by poor lending practices to create buyers from previously ineligible individuals. Many of the loans were known as adjustable-rate mortgages, which offered low introductory rates and could increase after a few years. When interest rates rose, values of homes took a nosedive and many people ended up defaulting on the loans.

What You Can Do

With bubbles, there is a pattern: something exciting gets investors’ attention, prices of an asset increase and more people jump on the bandwagon causing gigantic price increases. A price drop then causes mass panic leading to a sell-off that renders the asset in question much less valuable. The attention-grabber might be low interest rates, attractive debt, or a ground-breaking new technology.

The best thing you can do is remember this history and use it to avoid falling victim to a bubble burst. Some people became rich during each of these bubbles, but many more people lost significant money. When your friends, coworkers, neighbors, and family members are all emphasizing that you must get into something or you’ll miss out, take a step back and think. Understand that there is no such thing as free lunch, and that get-rich-quick schemes are just schemes.

If you want to become wealthy over time and stay on track with your financial goals, invest in a broadly diversified portfolio in line with your goals and risk tolerance, stay consistent with your investment strategy, avoid over-leveraging yourself or entering a debt contract with unfavorable terms, and leave the new, shiny thing to the speculative investors who can afford to have their investments become worthless.

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