The way bubble gets created...funny but true.

Imagine a stock priced at Rs 100 and having a market cap of Rs 10,000 (market cap = share price x total number of shares of a company . In this case 100 x 100). 

 

One day a fund decides to buy 5% of the company at Rs 120 per stock and thus pays Rs 600 towards the purchase. 

 

On seeing this transaction, other shareholders would be reluctant to sell their shares below Rs 120. 

 

This in effect would now make the new price of the stock as Rs 120 and push up the market cap of the company to Rs 12,000. 

 

You would have noticed the magic of the modern monetary system. A monetary transaction of Rs 600 has pushed up the wealth of investors by Rs 2,000. 

 

Thus, the overall wealth has gone up by 2,000 while the money involved is just Rs 600.

It should be noted that a similar magic was behind the creation of the biggest bubble in history. The US real estate bubble or what is now popularly known as the subprime bubble. 

 

All that the US authorities had to do was encourage a few more housing transactions so that prices could be pushed up. 

 

Thus, interest rates were lowered and more people were brought into the housing market. 

 

It should be noted that if prices for even 5% of the homes went up, the remaining 95% would also witness a similar rise in value and thus, overall wealth was increased.

So far, so good. 

 

The problem arose when home owners started assuming that their wealth was money and hence, would never go down. 

 

In fact, they went ahead and even borrowed fully against this new found wealth of theirs. The end result? 

 

When prices collapsed, their wealth came crashing down, leaving them with the huge debt burden. 

 

So, where did homeowners go wrong in US? 

 

They made the cardinal sin of equating wealth with money. To make matters worse, they even borrowed against wealth. 

 

I hope you would be careful not to make a similar mistake in your lifetime. 

 

Please bear in mind that difference between wealth and money is day and night. 

 

If debt is made available, the former can be increased at will. 

 

But not the latter.

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