Definition and examples of the dot-com bubble
How did the dot-com bubble work?
What does this mean for individual investors?
Definition and examples of the dot-com bubble
The dot-com bubble was an asset valuation bubble that occurred in the 1990s. It led to a recession caused by heavy speculative investments in internet-based companies. The bubble burst in early 2000 after investors realized that many of these companies had unviable business models.
How did the dot-com bubble work?
The internet was a hot topic during the 1990s, leading many investors to anticipate a profitable future for internet-based companies. This resulted in increased investment in technology startups, driving their stock prices to higher levels. Many companies even changed their names to include “.com” or “.net” or “Internet” – this simple change contributed to those companies outperforming their competitors by 63%.
The bubble peaked when daily trading on the NASDAQ reached 5132.52 in March 2000, before bursting later that year.
The value of many technology companies declined after investors recognized that these companies had little hope of making a profit. This led to panic selling, and by the end of 2000, the NASDAQ had fallen by more than 50%, dropping below 2500 in December 2000. This resulted in a recession in March 2001, with many companies shutting down. People lost their investments, and tech employees lost their jobs.
It took until 2008 to surpass unemployment levels in some high-tech industries before the recession, which rose by 4% from 2001 to 2008. The technology industry in Silicon Valley took longer to recover – some companies had to move production stages to lower-cost areas.
Although the dot-com bubble caused chaos in the stock market leading to lost investments and jobs, it had a specific benefit. The influx of capital into the technology industry contributed to the installation of fiber optic cables across the country. This increased nationwide connectivity and laid the infrastructure for many modern tech companies.
One major contributor to the dot-com bubble was the lack of good due diligence by investors. Investments in these technology companies were high-risk. People invested without strong profitability indicators based on data and logic, such as the price-to-earnings ratio – some even created unusual non-quantitative quality metrics. Many investors expected internet-based companies to succeed simply because the internet was an innovation, even though tech stock prices soared well above their actual values.
Undoubtedly, this narrow investment strategy blinded investors to the red flags that ultimately signaled the bubble’s burst.
What does this mean for individual investors?
If you want to protect your investment portfolio from “bubble investments,” be wary of herd mentality. David L. Bahnsen, founder and CEO of the bilingual coastal private wealth firm The Bahnsen Group, told The Balance in an email to be cautious about what other investors are saying and doing.
“When you hear people starting to say things like ‘this time, it’s different,’ or ‘cash flow doesn’t matter,’ or – my personal favorite – ‘valuations are irrelevant,’” Bahnsen said. “When common sense goes out the window, as evidenced by almost social dialogue, it means that problems are on the horizon.”
To protect
Save yourself from risky speculative investments, consider avoiding them altogether.
“Trying to play in a bubble thinking you can time your exit and leave the hot potato to someone else is playing with fire”, said Bahnsen. “If you don’t know why you’re investing in something other than ‘everyone else is doing it’ or ‘it’s been going up so I assume it will continue’ – then don’t invest”.
Instead, rely on reliable indicators to qualify your investment decisions. Bahnsen encourages investors to consider factors such as cash flow, earnings, profitability trajectory, and other aspects, in addition to a “balance sheet that can withstand temporary hardships”.
Source: https://www.thebalancemoney.com/what-was-the-dotcom-bubble-5209336
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