The Dot-Com Bubble: Causes and Collapse Explained

Introduction: The Internet and the Origins of the Bubble

The technology boom of the 1990s provides a valuable illustrative case for understanding financial bubbles. The advent of the Internet in 1994 provided the genesis for a run on technology stocks, much in the same way that previous bubbles — in industries like railroads — had occurred. The fundamental principle behind the bubble was that investors believed the new technology was transformative and that this transformation would produce massive stock market winners. Being outsiders with little to no knowledge of the industry, most investors then made irrational investments in virtually anything connected to it, leading to a speculative boom.

Under normal market conditions, a baseline assumption is that investors are rational — meaning they pay more or less fair market value for assets. However, to invest rationally, one must understand what one is investing in. 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 its commercial potential. As a result, investors found themselves drawn to a rapidly growing industry of uncertain promise that nonetheless seemed capable of becoming a commercially dominant phenomenon (Investopedia, 2016).

How Investor Irrationality Fuels Speculative Booms

The promise of a transformative new 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 large returns on the new technology. Without that knowledge, there was no ability to distinguish good companies from bad ones. Venture capitalists, normally more cautious in their investments, 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. Under normal circumstances, a company with no viable business model could never receive venture capital — much less go public — but during the bubble they did, because a large number of general public investors wanted in on the action (Investopedia, 2016).