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The Dot Com Boom

In: Business and Management

Submitted By kakn
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The Dot com boom/bust An economic bubble exists whenever the price of an asset that may be freely exchanged in a well-established market first soars to levels that cannot be justified (Ironman, 2010). ‘Investors’ push the price of the asset up by irrationally purchasing it. Eventually, the market realizes that the asset price is unjustified and the bubble bursts. More often than not, the bust happens in an all-of-a-sudden manner resulting in people losing huge sums of money. At the same time, these boom/ bust cycle has its beneficiaries, institutions and individuals who make huge amounts of money by ‘surfing’ the bubble or by fuelling it. In the case of the dot com boom, the culprits were the investment banks and some venture capital firms. Events leading up to failure One of the issues that I believe to be partly responsible for the dot com boom happened when the Taxpayer Relief act of 1997 lowered the maximum tax rate on capital gains for individual investors from 28 percent to 20 percent for assets held for more than 18 months. This perspective, proposed by Zhonglan Dai, Douglas A. Shackelford and Harold H. Zhang. In “Capital Gains Taxes and Stock Return Volatility: Evidence from the Taxpayer Relief Act of 1997“highlighted the fact that non- and lower dividend paying stocks experienced a larger volatility than high dividend-paying stocks. Stock volatility was substantially higher after 1997 and this may have contributed to the inflation of the bubble. It was not the main cause but it is worth mentioning this phenomenon as it may have facilitated the bubble. One of the biggest causes of the boom was the excitement of the commercial possibilities that the internet provided (Aches, 2010). This phenomenon was so large that every idea that sounded viable could fairly easily receive millions of dollars in funding. The basic principles of investment theory, with respect to understanding when a business would turn a profit, were ignored in many cases, as investors were afraid to miss out on the next big hit. They were willing to invest large sums in companies which did not have a clear business plan. This was rationalized by a so-called ‘dot-com theory’ i.e. for an internet company to survive and grow, it depended on rapid expansion of its customer base, which in most cases meant huge initial losses. The dot-com companies believed that the people who visited their websites would eventually become one of their customers. Sadly, they were mistaken. The success of almost all the Initial Public Offerings (IPOs) was a factor that contributed to the bubble. The values of the Dot-com companies were reaching unbelievable heights, increasing market confidence and fuelling the bubble. Everyone wanted a piece of the action.

There was an abundance of venture capital for dot-com companies whose ideas were centred on retail concepts that the owners had little to no understanding of (Breyer, 2001). The mismatch between dot-com pioneers’ backgrounds and understanding the business and what that they were trying to do was unbelievable. In addition to this, the investment banks were eager to take as many companies public as this was a profitable part of their business at the time. These banks often had their financial analysts back a certain stock to elevate its price. Celebrity Internet analysts such as Morgan Stanley's Mary Meeker and Merrill Lynch's Henry Blodget were to symbols of such cases (Levitt, 2001). What the public did not know was that more often than not, the investment banks had cashed out a long time ago and were releasing false information to boost the bubble. The fact that American publications such as Forbes and the Wall Street Journal encouraged the public to invest in risky companies despite many of the companies’ disregard for basic financial and even legal principles made the situation even worse (Rodrigo, 2012). Weaknesses in Risk Management Let us look at this issue from two perspectives: the investment banks and the investors. The investment banks had to come up with very creative ways of valuing these dot-com companies that had no earnings and no fundamental information. They valued these companies based on the number of prospective clients the company stood to have in the future. This figure was based on the number of clicks that the website received. Assuming that the investment banks made a conscious effort to carry out proper valuations (which they did not) this method is very flawed from a risk management perspective. These valuations were highly speculative because they assumed that each click corresponded to a future customer. They did not incorporate a down side, which turned out to be the reality, because they only focused on the up-side. In addition to this, the investment banks did not care to look into the management of the companies that they were taking public. The dot-com suffix took precedence over the competency of the management. As mentioned earlier, the mismatch between business venture and expertise in the field was immense and this ought to have been an issue that should have been addressed. The investment banks also exhibited bad risk management policies when the abolished the autonomy of their IPO and analysis departments. They forced their financial analysts to give buy and hold recommendations in stocks that they had interests in even though the analysts

believed that the stock were useless investments. I must emphasise that these banks failed to manage these risks because they stood to benefit from the consequences. From the perspective of the investors, they failed to carry out any extra analysis of the companies and bought into certain stock just because everyone was buying into it. This is very poor risk management considering that people were investing huge sums of money without any solid reason. Investment, as defined by Benjamin Graham, guarantees safety of principle and is done with thorough analysis. Many of the dot-com investors failed to meet both as part of risk management. Deficiencies in Prudential Regulation It is worth noting that previous literature suggests that asset bubble prices that involve fluctuations in the supply of credit are far more damaging than those that do not (Citizendium, 2011). Hence, the dot-com bubble did little damage as compared to the subprime debt crisis because it was not credit financed. Having said this there were a number of deficiencies in the regulation, the first being allowing companies to go public without a solid history of operation. There ought to have been regulation in place that set guidelines on whether a company qualifies to go public or not. The regulators did not pay close enough attention to the internal operations of these investment banks especially when most of their financial analysis lost anonymity and started working hand in hand with the IPO departments. The regulators failed to stop venture capitalists and other parties from cashing out huge amounts of money in new internet companies after the lock-ups expired. This was a very serious issue that caused public outcry upon its discovery, especially because regulators did not prevent it from happening and it was at the public’s expense. Conclusion The dot-com boom and bust cost investors millions, if not billions of dollars. Some parties benefited from the melee while others, the majority, suffered miserable losses. It seems that the United States of America falls is always a victim to financial disaster, the Global Financial Crisis erupting a few years after the dot-com bubble burst. The dot-com bubble was

a typical bubble that could form in any economy with the perfect conditions and industry practices. But the worst was yet to come. History has a habit of repeating itself. References Aches. (2010, March 12). The Dot-com Bubble. Retrieved from The Bubble Bubble Website: http://www.thebubblebubble.com/dotcom-bubble/ Breyer, J. (2001, May 10). The IPO Game. (M. Smith, Interviewer) Citizendium. (2011, June 6). Financial Regulation. Retrieved from Citizendium Web site: http://en.citizendium.org/wiki/Financial_regulation#Asset_price_bubbles Ironman. (2010, December 16). Here's Why The Dot Com Bubble Began And Why It Popped. Retrieved from Business Insider Australia Web site: http://www.businessinsider.com.au/heres-why-the-dot-com-bubble-began-and-why-itpopped-2010-12 Levitt, A. (2001, May 16). Boosting the bubble? analysts, ipos & the media. (M. Smith, Interviewer) Rodrigo. (2012, October 16). 2001 dot-com Bubble: its causes, effect, and lessons learnt. Retrieved from The WritePass Journal Website: http://writepass.com/journal/2012/10/2001-dot-com-bubble-its-causes-effect-andlessons-learnt/…...

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