Speculative bubbles form when exaggerated expectations about future growth or asset price increases lead to frenzied trading. Investors get caught up in the hype, driving demand and prices beyond the assets' true worth.

The bubble eventually bursts when prices realign with actual values, often leading to a sharp drop and widespread panic selling. These bubbles aren't limited to one area; they can appear in various economic sectors, stock markets, or even entire economies.

Historically, speculative bubbles have been a recurring phenomenon. Despite advancements in economics and technology, they continue to emerge. Internet growth fueled the 2001 tech bubble. The 2008 real estate bubble burst, triggering the global financial crisis. Today, intelligent financial traders use derivatives or short-sell securities to profit from these sudden price increases.

Five Phases of a Speculative Bubble

1. Initial Shift in Perspective

In the first phase, investors focus heavily on a new trend or change in economic policy. This could be anything from groundbreaking technology to a long period of low interest rates. The critical factor here is a shift in investor attention towards something new, sparking interest in speculative asset bubbles.

2. The Rise in Activity

Next comes the stage where prices start to climb. The increase begins slowly but accelerates as more investors join out of fear of missing out on a profitable opportunity. This phase is crucial to forming a historical speculative bubble because momentum builds.

3. Peak Enthusiasm

The third phase is characterized by extreme optimism. At this point, rational thinking often takes a backseat, and the market's movement is primarily driven by sheer momentum. This is a defining moment in a speculative bubble, where excitement peaks.

4. Realization and Withdrawal

Strategic exits from savvy investors mark this stage. Sensing that the bubble might soon burst, these investors start to sell their holdings. It's a period of profit-taking, where the first signs of skepticism about the sustainability of the speculative asset bubble begin to emerge.

5. The Inevitable Collapse

A sudden and sharp decline marks the final stage. Triggered by specific events or a series of events, this phase sees the bubble burst, and prices plummet rapidly. It's a period of panic and rapid sell-offs, bringing the speculative bubble to a dramatic end.

The Most Prominent Speculative Bubbles

The Tulip Craze in the Netherlands

In the 1630s, the Netherlands experienced an extraordinary speculative asset bubble called the Tulip Craze.

This historical speculative bubble saw an unprecedented rise in the value of tulips. Specifically, from November 1636 to February 1637, the price of tulips increased twenty times. Earl A. Thompson, a former economics professor at UCLA, highlighted this phenomenon. However, by May 1637, the value of these flowers plummeted, decreasing by 99%.

This speculative bubble wasn't limited to a small group; it involved much Dutch society. Remarkably, during the height of this bubble, the price of some tulip bulbs exceeded that of many houses.

This situation exemplifies how a speculative asset bubble can capture the public's imagination and lead to extraordinary market behaviors. The Tulip Craze remains a classic example of how speculative bubbles can grow and then suddenly burst, impacting a broad range of people and causing significant financial upheaval.

Japan's 1980s Economic Bubble

Japanese economic conditions in the 1980s demonstrate how speculative asset bubbles can form. Japan's economy tanked in 1986 after the yen appreciated in the early 1980s. The government used monetary and fiscal measures to revive the economy.

These steps, however, were so practical that they led to unchecked speculation. This speculative bubble saw a dramatic rise in the prices of stocks and urban property. From 1985 to 1989, the value of both these assets tripled.

An astonishing illustration of this bubble was the valuation of the Imperial Palace in Tokyo in 1989. Its value was estimated to be higher than all the real estate in California combined. Unfortunately, this bubble was unsustainable. By 1991, it had burst, leading Japan into a period of deflation and slow economic growth that lasted for a decade.

Dot-com Bubble of the 1990s

One of the most significant speculative bubbles was the 1990s dot-com bubble. This era saw fervent speculation in "new economy" internet-based businesses. The excitement around the potential of the internet led to sky-high valuations of numerous dot-com companies, often immediately after they were publicly listed.

The NASDAQ Composite Index, which mainly consisted of technology and dot-com stocks, reflects the scale of this bubble. Beginning at 750 points in 1990, the value quickly rose to over 5,000 by March 2000.

Long-term exponential growth was unsustainable. The index fell 78% in October 2002, triggering a US recession. In 2015, the NASDAQ reached its highest level since 2000.

South Sea Bubble

The South Sea Bubble was an early 18th-century financial crisis. South Sea Bubble, a 1720 speculative bubble, had more complicated origins than the Tulip Craze.

The 1711-founded South Sea Company received exclusive trading privileges from the British government with Spanish colonies in South America. The East India Company's success and profitable trade with India sparked investor interest in South Sea Company shares, prompting this move.

The company's directors promoted exaggerated stories of immense wealth in the South Seas (now known as South America), leading to a surge in share prices. From January to July 1720, the value of these shares skyrocketed from £125 to £950—an increase of more than eight times.

U.S. Housing Market Rise and Fall

After the NASDAQ dot-com bubble burst in the early 2000s, many American investors switched to real estate, believing it was more stable. This change greatly affected the housing market. The U.S. Bureau of Labor Statistics reported that house prices nearly doubled from 1996 to 2006. The most significant increase was between 2002 and 2006.

This period saw an unprecedented housing price increase. However, an unsustainable surge was evident. Mortgage fraud, condo trading, and sub-prime borrowing increased during the historical speculative bubble. These factors caused a real estate speculative asset bubble.

After peaking in 2006, the U.S. housing market fell. The average US home value fell 33% by 2009. The housing market shift contributed to the worst global economic downturn since the Great Depression. The Great Recession is currently underway.