26504696
Description
Flashcards by cecilia valente, updated more than 1 year ago
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Created by cecilia valente
over 3 years ago
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| Question | Answer |
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Bubbles and Crashes
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* Fasten your seatbelts |
| * Investors allocate their resources to different asset classes according to their... | * Time Horizon * Risk Appetite * Risk Tolerance * Risk/Reward trade Off |
| * Investors' main object is to grow their wealth AND beat inflation, usually over the medium-long term (10+ years). | * But we are not always rational. This is why bubbles and crashes occur |
| * When the prices of stocks or other assets grow quickly and for no objective reason, it is the beginning of irrational price growth known as a 'bubble' | Examples of objective reasons for a rise in a company's share price. A company may trade in 1) A commodity/good/service that has become scarce 2) A commodity/good/service that has become fashionable 3) Innovative technology 4) Has access to and/or the development of 1), 2), 3) 5) Or because investors have no other way to beat inflation (impossible to beat inflation with any savings products because these products offer very low rates of interest) |
| * When a 'bubble' bursts, the underlying prices of the assets/goods/services that caused that bubble collapse to pre-'bubble' levels | * The consequences can extend to 1) a class of investors (Tulip Mania) 2) a whole country (South Sea Bubble) 3) the whole world (Wall Street Crash 1929,dot com bubble 2001, 2008 Financial Crisis) depending on the investor base (who/how many invested) |
| * Each bubble is different but there are a few patterns of investor-behaviour common to most bubbles and prompted by so-called 'Irrational exuberance' | Irrational exuberance can manifest itself as ... 1) Wisdom of the crowds (herd instinct) syndrome: if other investors buy this stock, I will buy it too |
| 2) Past success: what was successful once will be successful again | 3) This time it is different: this is NOT a bubble because this stock/sector is special BOOM! CRASH! BANG! |
| Why do bubbles burst? Good question... There are usually a few reasons. Some call this 'The Greed/Fear Cycle' | A bubble bursts when * Initial profit taking: a few investors (or speculators) sell off when they believe their stocks have reached peak price. |
| FEAR starts with * Panic selling: other investors find out and they too sell off, prompting panic stock sales | * Panic selling spreads and can move on to other stocks/sectors, no matter how solid they are |
| * Trust and confidence evaporate, investors seek 'safe havens', such as sovereign bonds * More people start saving and cutting on their expenses because they expect things to get worse | * This leads to a saving glut (Do you remember: J. M. Keynes' 'Paradox of Thrift'?) |
| GREED SETS IN * With stock prices at rock bottom levels, some investors/speculators buy shares, hoping to make a high profit when prices pick up | * As things improve more people move their money from 'safe havens' back into stocks and shares, prompting a price surge... ...The GREED/FEAR CYCLE STARTS AGAIN |
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