What is an asset bubble?

An asset bubble refers to a situation in which the prices of assets rise significantly, often driven by exuberant market behavior and speculation, without corresponding increases in fundamental values. This rapid inflation of asset prices is typically followed by a sudden collapse or crash, where prices plummet back to more realistic levels, often causing significant financial losses for investors.

The essence of an asset bubble lies in the disconnect between the market price and the intrinsic value of an asset. During the bubble phase, investors may become overly optimistic and may buy into the asset not based on its true worth, but on the expectation of continued price increases. Eventually, when the demand fails to sustain these inflated prices, the bubble bursts, leading to a sharp decline in asset values.

In contrast, gradual increases in asset prices, stable market conditions, or reliable investment returns do not fit the definition of an asset bubble, as they suggest more stability and a correlation with the underlying economic fundamentals. Thus, the correct identification of an asset bubble as a rapid inflation of prices followed by a crash accurately reflects this phenomenon.