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At the dawn of the millennium, the âdot-com bubbleâ burst, and many tech companies either went bankrupt, or saw their values plunge. Many recovered, others did not. But it was a classic case of a market bubble, and there are lessons to be drawn from it.
A bubble comprises numerous factors â such as rising stock valuations, an increase in initial public offerings (IPOs), and a focus on buzz over basics â and financial professionals are always on the lookout for the next one. Here are five lessons from the dot-com bubble and the financial crisis that followed.
Key Points
⢠Asset bubbles may arise when investors’ extreme enthusiasm overshadows researching company fundamentals.
⢠Diversification of assets may help to shield a portfolio against sharp market downturns.
⢠Momentum trading demands discipline and paying close attention to market movements to avoid prolonged holding.
⢠Historical events may provide insights but not necessarily forecasts â itâs important to view potential investments in context of the current market.
⢠The Dot-com bubble burst during the middle of 2000.
What Caused the Dot-com Bubble, and Why Did It Burst?
Back in the mid-1990s, investors fell in love with all things internet-related. Dot-com and other tech stocks soared. The number of tech IPOs spiked. For example, one company, theGlobe.com Inc., rose 606% in its first day of trading in November 1998.
Venture capitalists poured money into tech and internet start-ups. And enthusiastic investors â often drawn by the hype instead of the fundamentals â kept buying shares in companies with significant challenges, trusting theyâd make it big later.
But that didnât happen. Many of those exciting new companies with optimistically valued stocks werenât turning a profit. And as companies ran through their money, and fresh sources of capital dried up, the buzz turned to disillusionment. Insiders and more-informed investors started selling positions. And average investors, many of whom got in later than the smart money, suffered losses.
The tech-heavy Nasdaq index had climbed nearly 600% between 1995 to 2000. The gauge however slid from a peak of 5,048.62 on March 10, 2000, to 1,139.90 on Oct. 4, 2002. Many wildly popular dot-com companies (including Kozmo.com, eToys.com, and Excite) went bust. Equities entered a bear market. And the Nasdaq didnât return to its peak until 2015.
What Can Investors Today Learn from the Past?
Every investment carries some risk, and volatility for stocks is generally known to be higher than for other asset classes, such as bonds or certificates of deposit (CDs). But there are strategies that can help investors manage that risk.
Here are some lessons:
1. Diversification Matters
One of the most established strategies for protecting a portfolio is to diversify into different market sectors and asset classes. In other words, donât put all your eggs in one basket.
It may be tempting to go all-in on the latest hot stock, or to invest in a sector youâre intrigued by or think you know something about. But if that stock or sector tanks, as tech did in 2000, you could lose big.
Allocating across assets may reduce your vulnerability because your money is distributed across areas that arenât likely to react in the same way to the same event.
Diversifying your portfolio wonât necessarily ensure a profit or guarantee against loss. And you might not be able to brag about your big score. Over time though, and with a steady influx of money into your account, youâll likely have the opportunity to grow your portfolio while experiencing fewer gut-wrenching bumps along the way.
2. Ignoring Investing Basics Can Have Consequences
Even as the stock market began its meltdown in 2000, individual investors â caught up in the rush to riches â continued to dump money into equity funds. And many failed to do their homework and research the stocks they were buying.
Prices didnât always reflect underlying business performance. Most of the new public companies werenât profitable, but investors ignored poor fundamentals and increasing warnings about overvalued prices. In a December 1996 speech, then Federal Reserve Chairman Alan Greenspan warned that âirrational exuberanceâ could âunduly escalate asset values.â Still, the behavior continued for years.
When Greenspan eventually tightened up U.S. monetary policy in the spring of 2000, the reaction was swift. Without the capital they needed to continue to grow, companies began to fail. The bubble popped and a bear market followed.
From 1999 to 2000, shares of Priceline Inc., the name-your-own-price travel booking site, plunged 98%. Just a couple months after its IPO in 2000, the sassy sock puppet from Pets.com was silenced when the company folded and sold its assets. Even Amazon.comâs shares suffered, losing 90% of their value from 1999 to 2001.
And it wasnât just day traders who were losing money. A Vanguard study showed that by the end of 2002, 70% of 401(k)s had lost at least one-fifth of their value, and 45% had lost more than one-fifth.
Valuing a Stock
There are many different ways to analyze a stock youâre interested in â with technical, quantitative, and qualitative analysis, and by asking questions about red flags. It can help in determining whether a company is undervalued or overvalued.
Even if youâre familiar with what a company does, and the products and services it offers, it can help to look deeper. If you donât have the time to do your due diligence â to look at price-to-earnings ratios, business models, and industry trends â you may want to work with a professional who can help you understand the pros and cons of investing in certain businesses.
3. Momentum Is Tricky
Momentum trading when done correctly has the potential to be profitable in a relatively short amount of time, and successful momentum traders may turn out profits on a weekly or daily basis. But it can take discipline to get in, get your profit and get out.
Tech stocks rallied in the late 1990s because the internet was new and everybody wanted a piece of the next big thing. But when the reality set in that some of those dot-com darlings werenât going to make it, and others would take years to turn a profit, the momentum faded. Investors who got in late or held on too long â out of greed or panic or stubbornness â came up empty-handed.
Identifying a potential bubble is tough enough, and itâs only the first step in avoiding the fallout should it eventually burst. Determining when that will happen can be far more challenging. If day-trading strategies and short-term investing are your thing, you may want to pay attention to the trends and your own gut, and get out when they tell you itâs time.
4. History May Repeat, But It Doesnât Clone Itself
There are similarities between whatâs happening in the more recent tech sector and the dot-com bubble that popped in 2000. But the situations are not exactly the same.
For one thing, investors today may have a better grip on what the Internet is, and how long it can take to develop a new idea or company. Some stock valuations today are, indeed, stretched but not as stretched as they were during the dot-com bubble.
Though it can be useful to look at past events for investing insight, itâs also important to look at stock prices in the context of the current economy.
5. You Canât Always Predict a Downturn, But You Can Prepare
The dot-com stock-market crash hit some investors hard â so hard that many gave up on the stock market completely.
Thatâs not uncommon. Investorsâ decisions are often driven by emotion over logic. But the result was that those angry and fearful investors lost out on an 11-year bull market. You donât have to look at every asset bubble or market downturn as a signal to run for the hills. Also, if the market decline is followed by a rally, you could miss out.
One strategy â along with diversifying your portfolio â may be to keep a small percentage of cash in your investment or savings account. That way youâll have protected at least a portion of your money, and youâll be set up to take advantage of any new opportunities and bargains that might emerge if the stock market does go south.
Investors should also really look at a companyâs fundamentals as well. Does a business make sense? Does it seem like they can grow their sales and keep costs low? Who are the competitors? Do you trust the CEO and management? After deep research into these topics, if the company is still attractive to you, then it could make sense to hang on to at least some of the shares.
If youâre a long-term investor whoâs purchased shares in strong, healthy companies, those stocks could very well rebound. But this is an incredibly difficult process that even seasoned investors can get wrong.
The Takeaway
Asset bubbles like the dot-com bubble can have different causes, but the thing they tend to have in common is that investorsâ extreme enthusiasm leads them to throw caution to the wind. In the late-â90s and early-2000s, that âirrational exuberanceâ led investors to buy overpriced shares in internet companies with the expectation that they couldnât lose. And when they did lose, the dot-com craze turned into a dot-com crash. Investors who thought they had a piece of the next big thing lost money instead.
Could it happen again? Unfortunately, thereâs really no way to know when an asset bubble will burst or how severe the fallout might be. But a diversified portfolio can offer some protection. So can paying attention to investing basics and doing your homework before putting money into a certain stock. And it never hurts to ask for help.
Ready to invest in your goals? Itâs easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesnât charge commissions, but other fees apply (full fee disclosure here).
FAQ
What was the dot-com bubble?
The dot-com bubble was a period marked by rising tech stocks and tech IPOs in the late 1990s, which eventually led to a bubble burst. Many companies went bankrupt or lost significant value after the burst.
What caused the dot-com bubble to burst?
Some reasons that the dot-com bubble burst include the fact that many companies werenât profitable despite their lofty valuations, dried-up sources of capital, and fleeing insiders selling shares.
What are some lessons from the dot-com bubble?
Some lessons may include the fact that diversification is important, ignoring investment basics can have negative consequences, and that market bubbles are always possible, so investors should pay close attention.
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