What Caused the Dot Com Bubble: 3: Changing of the Conventional Wisdom of the US Society

In this chapter we’ll talk about more subtle things, which lead to some irrational behaviours of the investors during the Dot Com Bubble. Irrationalities of the investors is a very important reason for the formation of the dot com bubble. And several kinds of typical psychological failings like overconfidence, herding, mania and new paradigm mentality did turned up in the dot com bubble.

 

Buffett ever said that he was told by Graham that a good idea will always bring you with more troubles than a bad one, because people always forget about the limiting condition of applying the good idea.

 

Brennan (2004) suggested that before the Dot Com Bubble, there are several changes in the conventional wisdom. And here are the three main changes:

 

The first one is caused by the mean variance portfolio theory suggested by Markowitz. This made people more willing to buy diversified market portfolios rather to pick some ‘good’ stocks and made people more likely to buy stocks that are not very familiar with. And he said this principle gradually became a part of the new conventional wisdom before the Dot Com Bubble.

 

Secondly, he thought that the first comprehensive study of rates of return on common stocks which was completed in 1964 made an impact in the following change of the conventional wisdom of the public. The report showed that an equally weighted stock portfolio have an annual compound return of 9% during 1926 to 1960. Thus people will naturally think the return of the stock exceeds the return of bond over long period. Some of the people at that time even thought the risk in the long run of stock is lower that the bond.

 

The third element is derived from the efficient market hypothesis. This made the investors less likely to notice the fact that the price of the Dot Com companies was probably not right compared to its fundamental. What is interesting is that Richard Thaler, leader of behavioural finance, recriminated to Fama “The only one on the planet reluctant to admit the bubble of NASDAQ stock market in 2000.

 

These three factors, as long as an increasing number of people began to own stocks, made an impact on the stock market. Between 1989 and 1998 the number of individuals in the US who owned stock, either directly, or through mutual funds, or in a self-directed retirement accounts, rose from 42.1 million to 75.8 million, while the number owning stock directly or through mutual funds (but excluding retirement accounts) rose by more than 50% from 31.5 million to 48.5 million. In spite of the changing of the conventional wisdom, according to Brennan, the demise of the defined benefit pension plan also account for it.

 

These further confirmed the idea I have suggested in the former blog that: thought trend of the society changed before bubbles, which is usually an incentive of the formation of the bubble. More insights can be drawn from the book irrational exuberance. Another example is the bubble of Japan which happened at the end of the last century. The Yamato is known for its cautiousness. But what happened to them during the bubble? Because this is not the mainly point of my blog and the reason is very complicated (and still a controversy), I may not talk about it here. In my next blog, I will introduce a speech of Buffett during the Dot Com Bubble and try to give some suggestions to investors.

 

Reference:

Brennan, Michael J. "How did it happen?" Economic Notes 33.1 (2004): 3-22.