A Comprehensive Analysis of the Dot Com Bubble in Behavioral Finance

This essay provides a comprehensive analysis of the Dot Com Bubble, examining its formation, characteristics, and eventual crash through the lens of behavioral finance. The paper begins with an introduction to the bubble, highlighting its origins in the late 1990s and early 2000s, driven by investments in internet-based companies. A literature review establishes the background, emphasizing the role of innovation, the rise of the internet, and the speculative nature of the bubble. The essay then delves into the formation of the bubble, focusing on the role of familiarity bias and herd mentality among investors. It explores how the excitement surrounding internet stocks and the tendency to extrapolate expectations fueled market behavior. The discussion section applies behavioral finance principles, examining the impact of uncertainty, positive market sentiments, and the subsequent bursting of the bubble. The essay concludes by summarizing the key findings, highlighting the influence of psychological aspects like familiarity biases, overconfidence, and herding behavior in the formation and collapse of speculative bubbles. The work references several academic sources to support its arguments.

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Introduction
The dot com bubble or the internet bubble is known as the rapid rise in the U.S. technology
stock equity valuations. The bubble took place during the bull market in the late 1990s, and
was driven by the investments in Internet-based companies and associated industry sectors
(Hommes, 2017). It is one of the many other bubbles that is descriptive of influence of the
cascades of the information, which leads to herding in the stock market. It was back then in
90s and the early 2000s, when the market investors believed that the internet would yield a
positive impact on the revenues of the companies. One of the chief characteristics of the dot
com bubble is known to be the herd mentality. The following work is aimed at analyzing the
various aspect of the Dotcom bubble from the point of view of the behavioral finance.
Literature Review
Background of the dot com bubble
In the words of Joseph Schumpeter, innovation is the driving force of economic growth. It is
also further regarded that innovation are one of the main causes of the cyclical fluctuations in
the economy. The dot com bubble, as stated above circles around the development of internet
and communication technologies. The first step of the internet network were created in the
90s with the creation of the World Wide Web. However, in the words of (Colombo, 2012),
the technology was back then reserved to be used by only specialized categories of
individuals. It is significant to note that there were only 9 percent of Americans that were
using the internet technology during that period. The period from 1994 witnessed the internet
activity coming travelling to homes of the developed countries leading to the democratic use
of the internet. The time further saw the development of the internet companies in the regions
of the Silicon Valley.
Speculative bubbles are descriptive of a cumulative movement in the price of an asset, the
prices of which are high because of the belief of the speculators that the prices will rise even
more (Konstantinidis et. al, 2012). As per the theories of the behavioral finance, the
occurrence of the stock market bubbles is attributed to the irrational behaviour of the
investors. It is further stated that the bursting of the bubble can lead to the destruction of a
large amount of wealth. Further the said burst can cause economic and psychological and
behavioral distress. In the words of Steve Blank, (2011), as cited by Nash (2013), there are
distinct four phases of a bubble namely the stealth, awareness, mania and blow-off.

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Formation of the dot com bubble
It is significant to note that one of the major reasons that lead to the formation of the stock
bubbles is the familiarity bias. Familiarity bias refers to an act of developing the perception
about something based on the potential familiarity about the underlying commodity. Before
the formation of the bubble it was noted that the large numbers of people had begun to use
the internet. The internet technology was fresh, exciting to use, and appeared to render a huge
potential back then. Consequently the same led to the formation of the bias that they are
familiar with the internet stocks and the companies, thereby making them exciting
investments with enormous prospective (Scherbina and Schlusche, 2012). It is further
suggested that the internet related names such as with the extension “dot.com” attracted
positive affect during the bull phase of the market. In addition it is suggested by a number of
experts that the persistence of the monetary imbalance in one direction can result in the
development of the extrapolative expectations which is the tendency of humans to believe
that prices will continue changing in the one observed direction itself.
The widespread extrapolative expectations lead to the phenomena of the herd trading. The
herd trading further leads to the inefficiency of the market investors to restore the prices of
the stock to the levels of their original efficiency. The herd behaviour is characterised by the
fact that people who would normally not trade start investing in the shares in the hopes of
share prices being risen and consequent making of money thereon (Taffler, 2014). The boom
phase leads to the generation of the media interest for the shares thereby spreading the
excitement across the wide range of audience. This is further followed by the institutional

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investors joining the momentum discarding the common investment principles and even the
common sense. The herd behaviour of the investors is further characterised by the moods and
emotions being exchanged in the social interactions and forming the base for the financial
decisions. Stock markets are often the indicators of the social mood of the investors. A
positive feedback cycle comes into existence as marked by the continuous price rise,
consequent happy mood and enhancement in the optimism, thereby leading to the
development of the bubble. Peaks of the social mood are stated to be manias or panics and
affects investment behaviour largely. As the social mood is generated and directed towards a
trend, people follow others without any apparent reason, further leading to investors
analysing the similar pieces of information in a similar manner. The herding behaviour is
further followed by the overconfidence among the investors making them belief to know the
outcome of an event, as they have predicted the same. The overconfidence among the
investors further lead them to invest more and making them to invest beyond a rational level
(Taffler and Tuckett, 2010). In addition, the overconfident buyers tend to borrow the money
to invest more and more in the stock markets. This excessive investment eventually results in
denial of the actual stock market picture, in the hope of holding to the investments rather than
withdrawing money from them because of excessive money invested.
Market fall and crashing of the bubble
The bubble phase in the market leads to the unrealistic levels of the share prices. As the
market is driven by the social mood, the price fall in the shares of the popular companies
renders a negative signal to the investors. The negative signal leads to the decline in the
prices of the stock (Prieto and Perote, 2017). The formation of the herds led to the substantial
price movements as witnessed in the case of the dot com bubble. The reason it is regarded as
one of the biggest economic bubbles is because various range of investor such as banks,
individuals, financial institutions had bought the internet stocks in herds, irrespective of the
actual financial performances of the companies and their size of operations.
Discussion
On application of the principles of the behavioral finance principles to the dot com bubble,
the following points are noteworthy. The dot com bubble has the similar characteristics as
explained above and while the formation of the same has begun in the mid-90s, the same also
crashed in the year 2000. As per the literature review of the formation phase of the bubbles,
uncertainty of information is one of the primary causes of the high prices and high return

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volatility which led to the formation of the dot com bubble (Ranganathan, Kivelä and
Kanniainen, 2018). The internet market change can be stated to be visible with the initial
introduction of the public browser in the year 1995 by Jim Clark. The said introduction
resulted in the company’s overall market capitalization reaching the $2 billion and stocks
being risen from $28 to $75 in one day in just one day. The April 1997 can be regarded as
the primary starting point of the formation of the dot com bubble.
The positive sentiments towards the development of the internet and communication
technologies sent the positive signals in the market which is marked by the bloating for the
bubble. The said bloating can be characterised by the stock market indices like NASDAQ on
their all-time high levels. People had assumed during the information technology revolution
of the 1990s that a great profits would be made by the dot com companies (Miller, 2010).
Consequently, the period witnessed the realisations by the start-up companies in the
information technology sector and the telecommunications sectors that bringing an IPO
would lead to magnificent growth for the entities. The realisation served as the base for the
extreme fondness towards the telecommunication and information technology companies.
There were consistent growth forecasts for the said companies as against the traditional
businesses. In addition, the start-ups were extensively funded by the incubators, business
angels and the venture capitalists. It is significant to note that the a huge number of internet
start-ups that were financed by the credits and bank loans, in addition to the initial public
offering in the internet and telecommunication sector took place. The positive sentiments in
the market towards the said companies and start-ups led to their valuations being quite
exaggerated as against their actual profits. This was followed by the bursting of the dot com
bubble when it was realised by the investors that they had been following an irrational herd
rather the common sense and investing principles. However, the early 2000s witnessed the
interest rates being increased by the US Federal Reserve by 5 percent to 6.50 percent,
coupled by investors realizing the speculative bubble being formed as a result of the dot com
companies. The early 2000 witnessed the bubble being burst and consequent loss in value of
the NASDAQ.
Thus, as seen in the case of the dot com bubble, formation of the speculative bubbles is based
on the unusual and consistent rise of the prices of the stock beyond their intrinsic values.
These bubbles are mainly based on the certain behaviour of the investors as mentioned above.
However it is significant to note that herding behaviour can sometimes lead to the production
of the rational prices in efficient markets and therefore it has been identified as one of the

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most significant aspects of the behavioural finance, which can either lead to the rational
prices or the bubbles and crashes. However it is also important to note that the reason herding
is a double edged sword is because it tends to cease when the prices reveal the acquired
information, and therefore once the herding stops the probability of price change is zero.
Another aspect that must be noted in case of herding and familiarity bias is that they occur in
the events of the information scarcity in relation to a fresh commodity, for instance internet in
case of dot com bubble.
Conclusion
As per the discussions conducted in the previous parts, it can be stated that innovation as
driven by the globalisation and technological developments potentially impact the economic
growth and often lead to economic fluctuations across the globe. In addition to the above,
when it comes to the stock markets, psychological aspects of human behaviour such as the
familiarity biases, overconfidence, herding behaviour, irrational beliefs and emotions lead to
the formation of the speculative bubbles. The case study of dot com bubble was analysed in
the above work to shed light on the various aspects of the human behaviour which lead to the
various stages of bubble namely the formation, denial, and burst. Two of the main
behavioural aspect that have been identified and explored in detail in the above work are the
familiarity or cognitive biases and the herding behaviour.

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References
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