Factors in Financial Bubbles

Financial Bubbles The technology boom in the 1990s provides a valuable illustrative case for learning about financial bubbles. The advent of the Internet in 1994 provided the genesis for a run on financial stocks, much in the same way that previous bubbles in things like railroads occurred. The fundamental principle behind the bubble was that investors felt that the new technology was transformative, that the transformation would result in massive stock market winners.

Being outsiders with little to no knowledge of the industry, most investors then make irrational investments to anything in the industry, leading to a speculative boom. Under normal market conditions, a baseline assumption is that investors are rational, meaning that they pay more or less fair market value for things. However, to invest rationally one must understand that in which they are investing. The 1990s saw a rapid increase in the commercialization of the Internet.

Investors neither particularly understood the technology, nor was there a coherent sense in the market of the potential of this technology. Combined, investors found themselves with a rapidly-growing industry of uncertain commercial promise, but that seemed like it could become a commercially dominant phenomenon (Investopedia, 2016). The promise of a transformative way of doing business resulted in capital flowing into the industry. The sources of this capital, however, knew nothing about the Internet and were simply seeking to score a big return on the new technology.

Without the knowledge, however, there was a lack of ability to discern good from bad among companies. Venture capitalists, normally more cautious in their investment, poured money into all manner of companies based purely on speculation. Many such companies had no underlying business to speak of, or at best were many years away from profitability.

Normally, a company with no underlying business could never receive venture capital, much less go public, but during the bubble they did, because there were many more investors among the general public who wanted in on the action (Investopedia, 2016). Underlying this was irrationality. This level of irrationality had been seen before in bubbles. One key element is that the industry has to be nascent, such that most investors have insufficient knowledge to invest rationally. The industry, however, must also hold tremendous promise.

In many prior bubbles, such as with railroads, or the South Sea bubble in 1720, the vague idea that the new industry will result in great riches for investors helps to convince people to invest en masse in something that they know next to nothing about (Ofek & Richardson, n.d.). As the money poured into the industry, investors saw two things. First, that there were a few companies that appeared to have established leadership positions in the industry and pathways to profitability (if not actual profitability).

On the retail side, Amazon and eBay were notable early hits, and there were hits on the enterprise architecture side of the business as well, such as Cisco. These were companies that generally had viable underlying businesses. However, their valuations were already high, so investors sought out nascent companies that could potentially be "the next Amazon." Their lack of experience in the industry meant that they had little ability to recognize a good idea from a bad one. This lead to many moonshot IPOs over the bubble period.

Those in turn fuelled the bubble further, because they convinced even skeptical investors that a company didn't even need a good idea or viable business to earn them a quick return. More money plowed into the business, despite the knowledge that there was no rational reason to invest in many of the companies in the industry. The bubble would eventually burst when skeptics began selling in 2000. The bubble had grown very large in.