Effects of a bubble on the markets are obvious.
1. On the way up, investors become too confident about their anticipated returns.
2. Money floods in - part of the definition of a bubble - and prices rise to even more unrealistic levels.
3. At some point, air starts to come out of the bubble.
4. Share prices drop and some investors, including pension plans and other institutional holders, lose a lot of money.
5. Many equity investors feel burned and move out of the stock market for good, and it takes years for new ones to take their place.
6. The consequence of a bubble for markets, then, is to reward winners and punish losers with a savage intensity.
The influence of a bubble market on the broader economy maybe even more long lasting and more perverse. Here are some of the more important consequences of the technology bubble of 2000 in the U.S.:
1. Excessive investment in telecommunications and related industries, thanks to the funds available from stock offerings and borrowings that the bubble market made possible.
2. Expansion to the point of collapse, or near-collapse, by companies that were profitable but used the high price of their shares to make foolish acquisitions or increase capacity beyond what a sensible view of the future would have allowed.
3. Incompetent, dishonest, and fraudulent behaviour by corporate executives, boards of directors, auditors, investment bankers, security analysts, and other market participants.
Conclusion:
Competitive market economies have always been subject to business cycles.
Like all cycles, they are painful on the way down.
A wider acceptance of the principles of value investing may ease some of that pain the next time the mania sets in.
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