A financial bubble can be a market situation that many traders and investors may not readily recognize only until its too late. The many potential for profit in bubbles can sometimes be enough to keep many people from looking at the volatile situation from a realistic perception. But it is not entirely impossible not to recognize a potential market bubble whenever it happens.

Theory Of Financial Instability

An economist by the name of Hyman P. Minsky has developed an economic theory regarding financial instability that may help provide more insight into financial bubbles. Minsky identified five stages in a typical credit cycle that may influence the development of a bubble. They are:

Displacement. A displacement occurs when there is a sudden positive change in the market that may be brought about by an innovative new technology or a significant improvement in various factors that may influence the market.

Boom. Following a displacement which begins to attract more and more investors, prices begin to rise which results in a boom. During this stage, the market begins to get widespread attention that leads to more speculation that further drives the market upward.

Euphoria. During this stage, asset prices further skyrocket as speculation and demand reach outrageous levels. Investors and traders throw caution to the wind just so in order to get into the rapid growth and potential profit offered in the bubble market. It is during this phase that valuations may reach extreme levels.

Profit Taking. As the valuations of assets reach extreme levels, there might be other investors and traders that may begin to become more sensible and slowly realize the outrageous situation that the bubble market may be currently in. Smarter ones may begin to heed the warning signs and start selling out positions for profit. But when essentially a bubble would be near collapse may be quite difficult to determine.

Panic. During this stage, the market forces reverse their course. Instead of an upward climb, they descend as rapidly as they have risen previously. Faced with this uneventful situation, many investors and traders would want to limit the losses to their rapidly decreasing positions by liquidating them at any price. As the liquidation rate speeds up, the supply overruns the market and the prices slide very rapidly.