Markets

Surely you have heard of “bubbles” or “cracks”, but how can this have anything to do with the economy?

We call a financial bubble the phenomenon that occurs when the price of a certain asset no longer obeys real issues and grows unjustifiably for speculative reasons. Its name comes from what happens when the expectations of its growth become pessimistic. Crack. Explode!

Suppose you wake up one day and see that the price of PALL Inc. shares has increased by 5% overnight. What was $80 yesterday is now worth $84. You would probably be surprised and envious of all those who own shares, wouldn't you? Now imagine the same thing happening the next day. Of course, many people who woke up yesterday like you and saw how much PALL Inc. shareholders had earned, now decided to invest part of their savings in buying the company's assets. As the demand for this asset increased, its price went up again. This can be repeated on another day, and another, and another. But there comes a day when you make the decision: you don't want to be left out. You recover part of your savings and decide to buy shares of PALL Inc., which are now worth USD 120, 50% more than they were a short time ago. It doesn't matter, because you are confident that it will continue to rise. That night you go to sleep happy, because now you finally own PALL Inc. shares and you will not be left out of the growth that its share price will have from now on.

And so it is! The next day their price went up again. Now it is worth USD130. Since you bought a lot of shares, you have earned USD10 for each one of them. You start thinking about all the trips you will be able to take with your new income. About the renovations you'd like to make to your house. About the new sneakers you want to buy. 

And then you ask yourself, what does PALL Inc. do? Where does it get the income that makes your company profitable? It's not so clear to you. In fact, you start asking around and find out that no one around you knows. You decide to post it on a social network: Does anyone know what PALL Inc. does? When the question starts to occupy a relevant place in the public discussion, many of PALL Inc.'s shareholders start to doubt that their shares are as sustainable as they thought they were. So they decide to divest themselves of some of their shares. By divesting their shares (and given that as a result of the uncertainty there are no longer so many people willing to buy PALL Inc. shares), the price of PALL Inc. shares is reduced, and they return to the USD 120 they were worth when you bought them. Today you could not buy all the things you dreamed of yesterday, but you think that maybe it is only one day. However, the next day new shareholders decide to leave PALL Inc., which leads to a further reduction in its price, down to USD 100. You find that not only did you not gain, but you also lost USD 20 for each share you own. 

You wonder if it will be a temporary thing, but just in case, you decide that the next morning you will sell all your shares, taking your loss, to avoid being left with even less. 

The next day, however, no one is willing to buy the stock from you for $100. It has already become clear that PALL Inc. model is not sustainable, and no one wants to risk losing everything. They are willing to buy the stock from you for as little as USD 50. You decide to take the USD 50. The outlook is sad, but at least now you know what a financial bubble is.