I have a theory about bubbles, behaviors and breaking away from the herd

As much as we’d like to make our investment decisions with the cold calculation of a computer chip, our emotions and our behaviors often won’t let us. As the technology bubble of the late 1990’s demonstrated, it’s easier and less complicated to follow the herd than to do our homework and get a reliable barometer on a stock’s potential direction. But when the bubble burst, investors learned a lesson in financial behavior they’ll never forget.

In the prehistoric days of the 1990’s, when dot.com millionaires walked the earth and some shares of Internet stocks sold for about the same price as a new microwave oven or a round of golf at Pebble Beach, few investors wanted to hear about bubbles.

Perhaps that’s why when the technology bubble finally burst in 2000, so many investors were carried away by the herd, unable to sell their dot.com stocks and technology funds before it was too late.

Why the trouble with bubbles and what does financial behavior and dealing with change have to do with it?

First a short lesson on bubbles. Financial market bubbles happen when stocks rise in price, regardless of fundamental factors such as earnings or revenues. As a result, valuations ballooned to vastly over-inflated levels. That’s exactly what we saw in the dot.com gold rush of the late 1990’s, when many highly-regarded Wall Street analysts were hard pressed to properly valuate technology companies but proceeded to predict they would rise to $200, $300, and even $400 per share, anyway. Chasing the dream and ignoring the bubble, investors stampeded toward technology stocks with a vengeance, pushing stock prices up to historic levels and setting the stage for the technology bubble burst of 2000, in the process.

The technology bubble of the late 1990’s – like most market bubbles – had three stages.

• First, there was a shift in market psychology, driven by the Internet craze.

• Next, the share prices of technology companies rose until their valuations reached speculative heights.

• Then IPOs were floated to soak up capital. Before long, we saw IPOs that represented little more than a set of ideas and people in a prospectus. The notion of making products that people actually use, a la Proctor & Gamble or Ford Motor Company, was viewed as quaint by many investors. Once that rational set in, the bubble burst.

It hasn’t fully recovered yet. Even as the Dow Jones Industrial Average flirts with the 11,500 level in late 2006, few market observers know when the market will enjoy sustained upward momentum again.