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Periods of strong market returns are often accompanied by an uncomfortable question: are we in a bubble? With markets increasingly driven by a narrow group of fast-growing companies, heavy capital spending on artificial intelligence, and headlines comparing today with the late 1990s tech boom, investor anxiety is understandable.
The aim of this note is not to predict whether markets will rise or fall next month, or even next year. Instead, it is to explain what investment bubbles actually are, why they tend to form around new technologies, and how long-term investors should think and behave during these periods.
History shows that bubbles are not rare accidents; they are a recurring feature of financial markets. Understanding them can help investors avoid the most common and costly mistakes.
An investment bubble occurs when asset prices rise well beyond what can reasonably be justified by underlying earnings, cash flows, or long-term fundamentals. Importantly, bubbles are not caused by bad ideas. They almost always start with good or even transformational ideas that capture the imagination of investors.
A typical bubble follows a familiar pattern:
At this stage, investors often stop asking “what could go wrong?” and instead ask “how do I get exposure?” Bubbles are ultimately about psychology, not technology. Excessive optimism applied to something new is what pushes prices beyond reasonable bounds.
A crucial insight from recent research is that not all bubbles are equally destructive. The distinction between “mean-reversion bubbles” and “inflection bubbles” is particularly useful.
Whether today’s market environment will ultimately be labelled a “bubble” is unknowable in advance. What can be observed, however, is a combination of factors that historically tend to appear late in investment cycles as bubbles form.
Artificial intelligence has become a major driver of capital spending, corporate profits, and equity market returns. A small number of companies account for a very large share of market gains, while valuations reflect high expectations for very high future growth.
At the same time, awareness of bubble risk is unusually high. Investors openly debate excess valuations, and comparisons with past bubbles are widespread. This self-awareness may reduce the likelihood of immediate collapse, but it does not eliminate the risk of disappointment over time.
One important difference from past episodes is that much of the current investment is being funded by large, profitable companies using their own cash flows, rather than by speculative borrowing. That reduces systemic risk, but it does not guarantee strong returns for shareholders if investments fail to earn an adequate return on capital.
Periods of heightened optimism call for better behaviour, not bold predictions.
First, diversification matters more than ever. When returns are concentrated in a small number of stocks or themes, portfolios can become unintentionally exposed to a single outcome. Diversification across regions, sectors, and styles helps reduce reliance on any one narrative.
Second, expectations should be realistic. High starting valuations typically imply lower future returns, even if the underlying businesses continue to grow. Investors should distinguish between believing in a technology and assuming that today’s prices will deliver strong long-term returns.
Finally, patience is an underrated advantage. Long-term investing success is often determined not by brilliant decisions, but by avoiding poor behaviour during emotionally charged periods. Staying invested, rebalancing sensibly, and resisting the urge to chase the most popular trades remain powerful tools.
The Investment & Research team at PSK are always monitoring market conditions and data points to ensure portfolios align with our overall long-term objectives. If you’d like to discuss any of the points raised, please contact your Adviser or call us on (02) 8365 8300.
General Advice Warning - Any advice included in this article has been prepared without taking into account your objectives, financial situation or needs. Before acting on the advice, you should consider whether it's appropriate to you, in light of your objectives, financial situation or needs.
