Definition: An asset bubble is formed when the prices of specific asset classes are over-inflated due to excess demand for the asset as an investment vehicle. Prices rise quickly over a short period of time, and are not supported by underlying demand for the product itself. An asset bubble can be aggravated by a supply shortage, or an over-expansion of the money supply, but most modern asset bubbles are primarily a result of demand-pull inflation. It is a form of inflation that is not always accurately captured in the Consumer Price Index (CPI). For that reason, asset bubbles can be aggravated by low interest rates.
Asset Inflation in Gold
An asset bubble usually starts to form when investors all flock to a particular asset class, such as the stock market, real estate or commodities. An asset bubble occurred in 2011 with gold prices, which reached an all-time high of $1,895 an ounce in September of that year. Gold prices started rising in 2009, reaching a record high of $1,081 in November. Gold was bought as a hedge against the global financial crisis, not for its value in producing jewelry or dental fillings. Many thought the global economy would recover quickly. When it didn't, gold prices just kept rising for two more years.The Oil Asset Bubble
An asset bubble also occurred in another commodity, oil. It started in the summer of 2008 with oil prices. Investors got out of the stock market in 2007, and started investing in oil futures. At first, they thought that demand from China would outstrip supply due to a mild shortage in Nigeria. However, demand actually fell that year, thanks to the recession, and supply actually increased. This didn't stop the asset bubble from creating high oil prices, which set a record of $143.68 a barrel in July 2008. For more, see Gas Prices in 2008.The Housing Asset Bubble
An asset bubble occurred in 2005 with real estate. Derivatives such as mortgage-backed securities were insured by credit default swaps -- or so investors thought. Hedge fund managers created a huge demand for these supposedly risk-free securities, and therefore the mortgages that backed them. To meet this demand for mortgages, banks and mortgage brokers offered home loans to just about anyone. This drove up demand for housing, which homebuilders tried to meet. Many people bought homes, not to live in them or even rent them, but just as investments to sell as prices kept rising. When the homebuilders finally caught up with demand, housing prices started to fall in 2006. This burst the asset bubble, and subsequently led to the subprime mortgage crisis in 2006, the banking credit crisis in 2007 and finally the global financial crisis in 2008.How to Protect Yourself from an Asset Bubble
The hallmark of an asset bubble is irrational exuberance. Nearly everyone is buying that asset! And, for a long time, buying that asset seems profitable. Often the price just keeps going up for years.The problem is that it is very difficult to time a bubble. Therefore, follow the advice of most financial planners, which is to have a well-diversified portfolio of investments. Diversification means a balanced mix of stocks, bonds, commodities and even equity in your home. Revisit your asset allocation over time to make sure that it is still balanced. If there is an asset bubble in gold or even housing, it will drive up the percentage you have in that asset class. That's the time to sell. Work with a qualified financial planner, and you won't get caught up in irrational exuberance and fall prey to an asset bubble. Article updated March 20, 2012
Also Known As: asset inflation
