Cryptocurrency bubbles are periods of extreme price inflation followed by an abrupt fall. Their cause can range from simple speculation to various other sources.
Cryptocurrencies have experienced similar mania as housing and dotcom bubbles of old; however, there are distinct distinctions that set crypto bubbles apart.
The Displacement Phase
As cryptocurrency prices surge, new investors enter the market believing they’re purchasing an investment which will quickly multiply their money; unfortunately, however, this is often not true.
At its heart, crypto bubbles are driven by media coverage and the “fear-of-missing-out” phenomenon. Influential people will often promote their investments to encourage others to follow suit; examples could include tweets from high-profile figures like Tesla CEO Elon Musk encouraging others to invest.
At the end of this phase, people begin to question whether asset prices are overvalued; they take comfort in the “greater fool theory,” which states that someone will buy up their overvalued assets at any price. This leads into the final phase of any bubble: profit taking and securing profits.
The Boom Phase
As soon as news spreads of an asset’s price surge, people begin grabbing it up without considering its fundamentals or valuation. The “greater fool” theory dictates that investors will always find someone willing to purchase an investment regardless of its tangible worth.
Crypto was an exciting investment opportunity that lured many into its hype, leading to many people buying coins without fully comprehending what they were purchasing or understanding what the risks involved were. They saw an upsurge in market cap as an opportunity to become wealthy quickly; this herding behavior ultimately lead to bubbles; that is why having a solid plan when trading is essential if one hopes to avoid such herding behavior and its subsequent rise of crypto bubbles. Successful traders know this better and are capable of avoiding herding behavior that leads to cryptocurrency bubbles by creating strategies designed around trading plans such as these; those with whom experience are better able to avoid such unwise herding behavior that contributes directly or indirectly leading up to crypto bubbles.
The Euphoria Phase
Cryptocurrency investors may feel like they’re living in an economic bubble when looking at their favorite digital currencies’ prices. After all, cryptocurrencies have experienced massive price increases since 2021 began.
When prices rise rapidly due to a large influx of buyers, prices often skyrocket much beyond their true worth – this can cause prices to soar many times higher than their true worth, signaling a possible bubble situation.
At high prices, investors may become overwhelmed and start contemplating an exit strategy to minimize their losses – this leads to further sell pressure from these investors as more sell orders come pouring out and investments become liquidated in an attempt to limit further losses.
The Profit-Taking Phase
Cryptocurrencies can be vulnerable to various factors that could trigger a bubble, including influencer tweets or announcements at events. Before investing, it’s crucial that investors assess both value and vision of a coin; price alone does not represent value.
After the displacement stage, comes the boom phase. When prices increase rapidly and investors rush in to make money quickly, creating hype and fear-of-missing-out scenarios which drive prices skyward. At this stage, warning signs may begin to show, prompting alert investors to sell off their coins in order to prevent massive losses when the bubble bursts.
The Panic Phase
Once the euphoria phase passes, investors begin to realize that asset prices have become overvalued and begin panicking as a result.
Many investors, including well-known figures like Warren Buffett and Charlie Munger from Berkshire Hathaway, consider cryptocurrency to be in an economic bubble. Their assertion is that these assets do not serve any practical purpose in real life and therefore represent pure speculation.
However, the valuations of some cryptocurrencies have reached astounding heights despite this, surpassing traditional stocks or real estate valuations in many cases. Skeptics may be correct; asset bubbles have occurred repeatedly throughout history and they follow a predictable pattern which economist Hyman Minsky detailed in his Five Stages of a Bubble theory.