An asset bubble is a market phenomenon during which asset prices reach unsustainably high levels, that cannot be justified by underlying fundamentals. Asset bubbles are driven by optimism (which ultimately proves to be misplaced) that a particular asset class will continue to increase in price for the foreseeable future – as more and more market participants buy the asset class, its share price is pushed higher and higher; this, in turn, reinforces their view that the asset will do well going forward and this cycle continues until the price of the asset increases far beyond what its fundamentals can justify. Ultimately, however, bubbles burst, ending in heavy losses for investors that were lured to join the cycle, tempted by the attractive returns but unaware of the risks.
An example of an asset bubble that remains fresh in the minds of many investors is the dot.com bubble. In the late 1990s, the price of many technology-related stocks reached incredibly high levels that were completely detached from fundamentals. This cycle was fuelled by investors’ speculation about the future prospects of these companies. Eventually, however, fundamentals reasserted themselves (as they always do), bursting the bubble and leaving many investors disappointed and with large losses of capital. However, even in the dotcom bubble, genuinely active fund managers were able to find undervalued opportunities and to deliver positive returns to shareholders in the long-term.