Finance Dot Bubbles
Behavioral Finance and Dot-com Bubbles
- Introduction
The dot-com bubble was a stock market bubble happening from 1995 to 2001 in which the share prices of technology firms rose dramatically and then collapsed. It is a typical kind of market anomalies which cannot be explained by traditional finance.
In 1995, the rapid advances in information technology change the ways people learn, play and work. Numerous Internet firms start up their businesses at that time and hundreds of companies being founded weekly at peak. Investors responded to this with their huge amount of money. This has pushed up the dot-com firm values and thus their stock prices; lots of it. The rising price then attracted even more attention of investors. As such, the market was overpricing those companies severely. Unfortunately for many companies and investors, the growth of the technology sectors was proved to be illusory. Many dot-com and Internet companies folded and went bankrupt. The bubbles burst and triggered a mild economic recession in the early 2000s.
In this paper, I am going to examine the dot-com bubbles phenomenon by Theoretical Finance and Behavior Finance. In the section of Theoretical Finance, I will have a brief discussion on the key assumptions of Efficient market Hypothesis and explain why it cannot be applied to dot-com bubbles. In the section of Behavior Finance, I will go into details of several Heuristics and Bias - Herd Behavior, Overconfidence, Availability and finally the irrational consequence of being influenced by non information.
- Theoretical Finance
In an efficient market, on the average, competition will cause the full effects of new information on intrinsic values to be reflected “instantaneously” in actual prices.
- Eugene Fama
2.1 Efficient Market Hypothesis
Efficient Market Hypothesis (EMH) assumes rational investor behavior. According to EMH, stock prices reflect the firms' fundamental values, react to information promptly and accurately, show non-reaction to non-information.
Dotcom bubbles are a challenge for the EMH. During the formation of the bubbles, the phenomenon can be interpreted as the prices of technology stocks exceeding their fundamental values. Technology stocks were trading at multiple of earnings. Stock prices were as well too volatile to be explained by fluctuations in fundamentals.
Index
Figure 1, extracted from “The Rise and Fall of Internet Stock Prices”, graphs the index of an equally-weighted portfolio of the internet stocks over the sample period January 1998 to December 2000 versus S&P500 and NASDAQ. From October 1998 to March 2000, the return of equally weighted Internet index was increasing dramatically and it was far above that of S&P500 and NASDAQ. This cannot be an evidence that Internet stocks were trading exceeding their fundamental values, it does implies the Internet stock prices were soared to a very high level relative to the aggregate market. However, from April to November 2000, the share prices of Internet firms tumbled seriously. The upside view was disappeared in the few months. The excess volatility again is hard to be explained by EMH.
- Behavioral Finance
"Graham's conviction rested on certain assumptions. First, he believed that the market frequently mispriced stocks. This mispricing was most often caused by human emotions of fear and greed. At the height of optimism, greed moved stocks beyond their intrinsic value, creating an overpriced market. At other times, fear moved prices below intrinsic value, creating an undervalued market." - Robert G. Hagstrom
- Herd Behavior
Behavioral finance theory attributes stock market bubbles to cognitive biases that lead to herd behavior. Herb behavior occurs when people conforming to the crowd. This might be because people react similar to the same information. Another critical reason is people tend to follow the crowd when they confront their judgment in a big group. They seldom express their contrary opinions in front of the others.
Herd behavior is one of the key factors in dot-com bubbles formation. Millennium bug and the advent of technology successfully grabbed the attention of investors. They had invested huge amount of money into dot-com shares. This pushed up the stock price of Internet firms. By then, numbers of Internet firms start up their business at that time. Investors purchase securities when prices are rising. The overreaction overweighed the fundamental value of Internet firms and pushed up the prices even higher.
It shows clearly that the trading volume of Internet firms was soaring exponentially during dot-com bubbles from Figure 2 which is extracted from “The Rise and Fall of Internet Stock Prices”. The paper also mentioned the trading volume was reaching as high as 20% of the aggregate market. The social-proof herb behavior contributed so much on the dot-com boom. It is as well the reason that caused the bubbles burst. The massive selling of major high tech stocks (Cisco, IBM, Dell, etc.) had happened by chance simultaneously on a Monday morning. The enormous selling action triggered a chain effect among investors. Most of them were rush to clean up their position in Internet firms. This is observable from Figure 2 that the trading volume was dropping since March 2000. The herb behavior this time lowered the Internet share prices further and further and finally collapsed the dot-com bubbles.
- Overconfidence
Overconfidence is a kind of bias that people overvalue their ability and knowledge. They tend to overestimate the probability of getting success and underestimate the likelihood of being failed. This misleads people to assure some uncertainty that they cannot control. People attribute good decision to their own ability and relate the bad things to external factors.
In stock market, excessive trading resulted due to overconfidence effect. Investors are apt to exaggerate their talent and underestimate the likelihood of bad outcomes and risks. Overconfident investors trade more frequent than rational investors. They believe they are above average in terms of investment skills so they trade again and again in order to gain more in the stock market.
During the dot-com bubbles, everyone observed the stock prices and trading volume were going up explosively. Investors overestimated the accuracy of the information and believe this was a very good chance to get involved. Some of them may not aware of the firm's capital structure, strategy and market position etc before they put in a position. They traded because they are Internet firms. Overconfidence investors were overwhelmed by their supreme ability to determine Internet firms were all rewarding and under-judge the risks they were facing. They think they were making a right bet as the whole group.
- Availability
Availability is another kind of bias that people are too focus on the information that can be bought to their mind easily. Due to the retrievability of instances, people correlate an outcome with its likelihood to happen instead of their rational analysis.
Because of availability, investors often overvalue the available or the only information they have. Even though the information is sometimes irrelevant, investors tend to focus on the information they have to make judgment. On the other hand, they may tie in Internet stocks and good return together due to availability bias. Thus, they are more confident on trading Internet firms. This could be a reason of pushing up trading volume during dot-com bubbles.
- Reaction to non-information
Investors are irrationally influenced by dot-com effects and cosmetic effects of name changes. They generally react positively to the addition of “.com” to corporate names during the dot-com bubble period and to the deletion of “.com” from corporate names after the bubble burst. The share prices tended to increase with the name changes.
According to the research paper “A rose.com by any other name”, firms announcing name changes to a dot-com name earn a statistically significant abnormal return of 53% in a five days period around the announcement date during dot-com bubbles.
Firm name change is unnecessarily related to core business change. A firm named itself as dot-com can have totally no relationship with the Internet. They changed their names to dot-com mainly because of the dot-com effect and attract investors' interests.
Figure 3
Number of firms adding or deleting dot.com to/from their names
Number of firms
Index
Figure 3, extracted from “Price Reactions to Corporate Name Changes”, shows that numerous firms added “.com” to their names during dot-com boom while portions of them removed “.com” after dot-com bubbles burst.
There is no evidence showing corporate name change led to performance improvement. Instead, names changes seem to provide a strong signal to the market and attracted lots of investors to trade. The fact is investors influenced by cosmetic effect and placed their money in based on the non-information. Their irrational reaction is another example against EMH but Behavior Finance explained.
- Conclusion
In conclusion, Efficient Market Hypothesis may not be the best approach used to explain market anomalies. It is the most important and well known theory in the financial world. Efficient Market Hypothesis assumes people behave rationally in their financial decision. It eases the task to do asset valuation.
When it comes to the topics of speculative bubbles like dot-com bubbles we discussed in this paper, it is critical to bring in the ideas of Behavior Finance. Behavior Finance plays an important role of the ways investors think and behave. It states that investors are not always reacting in a rational manner. They may sometimes response with psychological biases. The financial decision they made may not be based on the throughout judgment. They could be due to the heuristic biases.
In the discussion of dot-com bubbles, we found that investors' overreaction could lead to bubbles formation and burst. Investors may follow the herd, being overconfidence and make judgment based on the ease access of information when they do trading. As a result, this formed another kind of market anomalies which is name change effect. In the age of dot-com bubbles, addition or removal of “.com” could bring abnormal profit to the firms which cannot be explained by rational behavior. By understanding Behavior Finance, we could be better aware of and avoid the common mental mistakes we may make.
- Reference
De Bondt, Werner F. M. and Richard H. Thaler (1985) “Does the Stock Market Overreact?” Journal of Finance 15 (3):793-810
Cooper, M., A. Khorana, I. Osobov, A. Patel, and P. Rau (2005b), “Managerial Actions in Response to A Market Downturn: Valuation Effects of Name Changes in the Dot.com Decline“, Journal of Corporate Finance, Vol.11, Nos.1&2 (March), pp.319-35
Eli Ofek and Matthew Richardson, “DotCom Mania: The Rise and Fall of Internet Stock Prices”, p.49-51
Michael J. Cooper, Orlin Dimitrov and P. Raghavendra Rau, “A rose.com by any other name”, Journal of Finance, p.5-11
Hung Wan Kot and Ji Zhang, “Price Reactions to Corporate Name Changes”, p.24
Markus Glaser and Martin Weber, “Overconfidence and Trading Volume”, p.28-31
Hirshleifer, D., 2001, “Investor Psychology and Asset Pricing," Journal of Finance, p.1533-1597
Giuseppe Cornicello, “Behavioral Finance and Speculative Bubble”, p.41-46
Jos´e Scheinkman and Wei Xiong, “Overconfidence and Speculative Bubbles”, p.30-32
Conrad, J. and Kaul, G., “Long-term market overreaction or biases in computed returns”, Journal of Finance 48, p.39-63
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