How Financial Bubbles Form: Timeless Lessons from the Psychology of Money

There’s a moment in every financial bubble when everyone knows it’s a bubble. The signs are obvious. Stocks, real estate, crypto—whatever the asset—are soaring at a pace that defies logic. People with no prior experience start talking about “once-in-a-lifetime” opportunities. Your cab driver is giving you stock tips. Your neighbor, who never cared about markets before, is now a “full-time investor.”

And yet, even when the bubble is clear as day, most people don’t sell. They ride it until the very end.

Why?

Because bubbles aren’t built on numbers. They’re built on emotions.

The Making of a Bubble

In The Psychology of Money, Morgan Housel highlights a simple yet powerful truth: People do not make financial decisions based on spreadsheets; they make them based on emotions, experiences, and the narratives they believe.

Every bubble begins with a compelling story.

Take the dot-com boom of the late 90s. The internet was changing the world, and everyone wanted in. The logic was sound—this was a technological revolution, just like the industrial age or the rise of electricity. But here’s the thing: bubbles aren’t about whether something is good or bad; they’re about how much people are willing to pay for that future.

Once people believe in a story, a second force takes over: FOMO (Fear of Missing Out).

You hear about a friend making 5x returns in a few months. A coworker just quit their job to trade full-time. The news is filled with success stories of everyday people turning small investments into fortunes.

And so, you convince yourself: This time is different.

The price of the asset keeps climbing, not because of fundamentals, but because people believe it will keep climbing. The moment an asset’s price is driven more by collective belief than by underlying value, you’re in bubble territory.

The Air Feeds Itself

The next stage is where things get really interesting.

As prices skyrocket, more people jump in. And as more people jump in, prices skyrocket further. It becomes a feedback loop:

1. Rising prices attract attention.
2. Attention attracts new buyers.
3. New buyers push prices higher.
4. Higher prices confirm the belief that “this is the best investment ever.”

At this point, skepticism is drowned out by enthusiasm. The cautious investors who say, “This doesn’t make sense” are dismissed as “too old-school to understand the new paradigm.”

You’ve probably seen this cycle before.

• Tulip Mania (1637) – Dutch traders paid fortunes for rare tulip bulbs, believing they’d only go higher. Until one day, they didn’t.
• The South Sea Bubble (1720) – A company with no real profits convinced thousands of people that it was the future. Then it wasn’t.
• The 1929 Stock Market Boom – “Stocks can only go up,” they said. And then came the crash that led to the Great Depression.
• Dot-Com Bubble (1999-2000) – Startups with no revenue were valued in billions. When reality kicked in, it was too late.
• The Housing Bubble (2000-2008) – Real estate prices soared as banks lent recklessly. But when the loans came due, the system collapsed.

Each time, people swore, this time is different.

It never was.

Why No One Sells at the Top

One of the most fascinating parts of a bubble is that even the smartest investors struggle to sell at the peak.

Why?

Because selling means admitting the party is over.

When you see your portfolio up 300%, you feel like a genius. Selling feels like walking away from something magical. And even if you want to sell, you hesitate:

• “What if it keeps going higher?”
• “What if I sell too early and regret it?”
• “I’ll just wait for one more rally.”

Here’s the kicker: even when prices start falling, people don’t sell. They convince themselves it’s a temporary dip. “This is just a correction. It’ll bounce back.”

Until it doesn’t.

And by the time panic sets in, it’s too late. The smart money has already exited, and the ones left holding the bag are retail investors who got in late, believing the dream was real.

The Aftermath: What Happens When the Bubble Pops

The moment a bubble bursts, the same forces that pushed prices up—excitement, speculation, and blind optimism—work in reverse.

1. Prices drop. At first, people think it’s a “healthy correction.”
2. Fear takes over. Investors start realizing something is wrong.
3. Margin calls & forced selling. Those who borrowed to invest are now in deep trouble.
4. Panic selling. Everyone wants out at the same time. Prices crash.
5. Disbelief. People hold on, hoping prices recover. Many never do.

And just like that, billions of dollars disappear overnight.

What’s left? A painful lesson.

So, Can You Avoid Bubbles?

Here’s the truth: No one can time the top of a bubble perfectly. Not even the pros.

But you can protect yourself.

• Recognize the signs. When people start saying “this time is different,” take a step back.
• Take profits along the way. There’s no shame in securing gains. The best traders do it.
• Don’t buy into hype. If an asset’s price is rising purely because people expect it to rise, be careful.
• Stay liquid. When a crash comes, cash is king.

Most importantly, remember this: Making money in a bubble is easy. Keeping it is the hard part.

Every financial boom has an end. Every speculative frenzy burns out. And every investor, at some point, will be faced with a choice: chase the dream, or cash out before the music stops.

Your move.