This article appeared in a newsletter produced by Joe Birkinbine of ATP Financial Services here in Steamboat. Joe is a financial planner as well as an instructor and trainer for pilots. I thought the article interesting enough to share.  Ulrich  

Price bubbles in technology stocks, crude oil, home prices, credit, and other areas posed far-reaching problems for investors.

For example, the past two recessions were each preceded by (and likely caused by) price bubbles: The recession that began in December 2007 was preceded by a bubble in real estate; the 2001 recession was preceded by a bubble in technology stocks.  Federal Reserve chairman Ben Bernanke told Congress that asset price bubbles and the financial booms that they cause were perhaps “the most difficult problem for monetary policy this decade.�

The hot topic right now seems to be where the next bubble will pop up in our economy. But can ordinary investors protect themselves from bubbles? Is it possible to tell the difference between an asset bubble and a legitimate investment opportunity?  What Is a Bubble?A bubble typically occurs when there is widespread speculation that a particular asset is going to increase in value. The subsequent spike in demand for the asset drives up the price, but when the anticipated gains don’t materialize, some segment of the investing public is left holding an overpriced asset. Losses occur as the market adjusts to represent the true value of the asset. Bubbles can occur in the economy at large, in a particular financial market, or in a particular security or commodity. Generally speaking, most bubbles get started with the belief that the investment is a sure thing and thus anyone who manages to purchase the hot asset is guaranteed a return because the price will always rise. One other common ingredient is the notion that fundamentals don’t matter anymore, which leads people into a things-are-different-this-time mentality.  A Saltwater BubbleHistory is littered with investment bubbles, but the first may have been the South Sea bubble, a stock scam in 18th century England. See if any elements of this story sound familiar. The South Sea Company was granted a monopoly on trading routes with Spanish South America in exchange for assuming England’s war debt. So great was the anticipated value of the trade routes that investors became desperate for South Sea Company stock. The company simply issued shares to meet the demand because there was no law to prevent it from doing so. It soon became quite fashionable to own South Sea shares. Many of England’s rich and powerful were drawn in, which, combined with the company’s lavish offices (built and furnished before any trade voyages were launched), further added to the perception of a sure thing. The share price peaked after appreciating 1,000%. When eventually it became evident that the company was making little profit and its officers had acted fraudulently, the share price plummeted. Thousands of investors were bankrupted, and not only because the stock crashed. In addition to spawning many copycat scams, the scandal caused bank failures and a loss of confidence in stock investing. The British government responded with legislation that later came to be called the “Bubble Act of 1720.�2 

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