A bubble in the financial context, generally refers to a situation where the price for an asset exceeds its intrinsic value. During a bubble, prices for a financial asset are highly inflated.

The terms "asset price bubble," "financial bubble" or "speculative bubble" are interchangeable and are more often than not. There is a failure to recognize that there is a select number of regular market participants and other forms of traders engaged in a speculative exercise which is not supported by previous valuation techniques.

Also, bubbles are usually identified only in retrospect, after the bubble has burst and many have had their time to complain about it.

In most cases, an asset price bubble is followed by a sharp correction in the price of the securities in question. In addition, the damage caused by the bursting of a bubble depends on the economic sector/s involved, and also whether the extent of participation is widespread or localized. Financial bubbles are quite simply made up of the same formula; consisting of a series of 3 steps.

1. Displacement: A displacement occurs when investors get enamored by a new paradigm, such as an innovative new technology or interest rates that are historically low.

2. Boom: Prices rise slowly at first, following a displacement, but then gain momentum as more and more participants enter the market, setting the stage for the boom phase. During this phase, the asset in question attracts widespread media coverage. Fear of missing out on what could be an once-in-a-lifetime opportunity spurs more speculation, drawing an increasing number of participants into the fold.

3. Euphoria: During this phase, caution is pretty much thrown out of the window, as asset prices skyrocket. During the boom people bought tech stocks at high prices, believing they could sell them at a higher price until confidence was lost and a large market correction, or crash, occurs. Bubbles in equities markets and economies cause resources to be transferred to areas of rapid growth. At the end of a bubble, resources are moved again, causing prices to deflate. Thus, there is little long-term return on those assets.

The strange thing with bubbles is that they almost rarely follow a specific route, as some manage to control a bubble before it gets out of control, ergo it is impossible to determine when or if a bubble will pop, but more likely determine its probability of various possible effects and how it may affect specific areas.

This article was issued by Steve Diacono, for Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.