What characterizes a financial bubble?

A financial bubble is characterized by a situation where asset prices significantly exceed their intrinsic value, driven primarily by exuberant market behavior rather than fundamental economic indicators. This phenomenon occurs when a substantial amount of speculative buying takes place, leading investors to continue bidding prices higher regardless of the underlying worth of the assets. The excess demand and positive sentiment foster an illusion of value that ultimately diverges from reality.

Asset prices during a bubble phase are typically inflated as a result of factors such as investor psychology, rapid market speculation, and herd behavior. As these prices rise, more investors enter the market, often motivated by the fear of missing out on potential gains, further intensifying the misalignment between market price and intrinsic value.

Once the bubble bursts, a correction occurs, leading to a swift decline in prices back towards their true valuation, often resulting in substantial financial losses for investors who were caught on the wrong side of the market. Understanding this concept is essential in the field of investments, as it illustrates the risks associated with irrational market behaviors and the importance of fundamental analysis.