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Technology Analysis & Strategic Management, Vol. 15, No. 1, 2003

Bursting the Bubble: A Case Study in Investor Behaviour


A The Austrian economist Joseph Schumpeter considered innovation to be the driving force of economic growth and argued that innovations were also the main cause of cyclical uctuations in the economy, an idea now well established in the economic literature. In this paper, the authors attempt to gain insights into the behaviour exhibited by investors before and after the market correction of the newly established Internet sectora technology with revolutionary potentialin the Spring of 2000 by structuring their analysis around the psychological themes of heuristic-driven bias, frame dependence, and inecient prices. Linear regression models are constructed using data collected on publicly traded Internet companies, market performance both before and after the collapse of the Internet sector stock prices in an attempt to assess whether or not market returns were correlated with certain specic measures of corporate internet performance. Finally, the authors draw inferences relating to the psychology of investor behaviour during this period based upon their empirical analysis, and conclude by summarizing the managerial implications of their ndings.

1. Introduction The Austrian economist Joseph Schumpeter1 considered innovation to be the driving force of economic growth and argued that innovations were also the main cause of cyclical uctuations in the economy, an idea now well established in the economic literature. It is further argued that clusters of innovations conduce to the growth of new industries such that when their diusion takes place it can amount to the emergence of whole new technological systems and that the impetus to economic growth comes, therefore, not from the rst innovations but from a pattern of change associated with diusion investment related to breakthroughs in fundamental science and technology, inventions, and the level of economic demand.2 It may be argued that recent developments and investment in electronics and computer technologies, new material technologies and telecommunications comprise such a cluster of fundamental innovations consistent with the new technological system thesis and that over the next few years Internet-enabling technologies will have the capacity to radically transform business operations and structure by facilitating business interfacing. Internet-enabling technologies certainly appear to have all the characteristics of a fundamental technological innovation with the power to transform global and economic development and thus, investors enthusiasm for them is understandable. However, we appear to have recently witnessed an overPeter Wheale is Director of Postgraduate Research Studies at the Surrey European Business School, University of Surrey, Guilford GU2 7XH, UK and Laura Heredia is a Business Analyst at Future Electronics, Colnbrook, Berkshire, UK.

ISSN 0953-7325 print; 1465-3990 online/03/010117-20 DOI: 10.1080/0953732032000046097

2003 Taylor & Francis Ltd

118 P. R. Wheale & L. Heredia Amininvestment in them far greater even than that of the Tulip mania in 1637, the South Sea bubble of 1720 and the British Railway euphoria of the 1840s.3 The classic theory of securities market equilibrium is based on the interaction of completely rational investors. However, several recent studies4 have explored alternatives to the premise of full rationality. Behavioural nance is a burgeoning eld that focuses on the psychological inuences of investors behaviour. According to Shefrin5 certain psychological phenomena pervade the entire landscape of investment and nance, and these phenomena can be organized around three themes: namely, heuristic-driven bias, frame dependence, and inecient prices. Using these three themes as a framework for our analysis, this study attempts to gain insights into the behaviour exhibited by investors before and after the market correction of the Internet sector in the rst quarter of 2000. Section 2 describes the rise and fall of the Internet sector during the late 1990s. Section 3 briey reviews the theoretical underpinnings of the psychology of investor behaviour. Section 4 describes the methodology we have used for our empirical analysis. Section 5 reviews our nding and explores some of the reasons for investor overcondence, and their overestimation of the quality of information signals about security values, before the market correction in spring 2000. Finally, in Section 6 we draw conclusions deriving from our empirical analysis and summarize some managerial implications of our ndings. 2. The Rise and Fall of the Internet Sector In the early period of the diusion of a major innovation new rms tend to be formed to exploit the new technology, and investment and employment in the associated industries tend to expand. The demand for Internet technology deriving from the huge potential of commercial Internet implementations by private and public organizations reinforced the favourable investment climate in the late 1990s for the newly created Internet rms funded by venture capital and it was claimed that Internet-enabling technologies would rapidly change the structure of the stock market and the corporate landscape.6 Enormous opportunities were considered to exist for those companies prepared to nd creative and unique ways to use the Internet to solve problems and provide novel services and products, and investment literature such as the Investors Guide also encouraged highly speculative investment.7 Figure 1 summarizes the estimated global e-commerce growth for business-business (B2B) and business-consumer (B2C) models. Some innovation studies have postulated the so-called push-pull models of innovation. The push idea is that innovation is pushed by scientic and technological breakthroughssometimes called capabilities push and the pull idea is that invention and innovation are stimulated by some perceived social need or market demand.8 Although evidence from empirical studies do not support simple linear-sequential models of innovation,9 it appears that Internet technologies and the formation of companies have been pushed by technological capabilities and to a much lesser degree pulled (by market forces), albeit in complex ways. A technological advance aecting part of a production process increases the pressures for technological advances in other parts of the process and may shift the responsiveness (elasticity) of technological substitution upwards. Process innovation, usually responses to a shift in demand or to increased costs in a rms production function, are typically embodied in bought-in capital equipment. Rosenberg10 convincingly argues that, historically, innovations aecting part of a production process lead to searches for innovations aecting other parts of the process11 but this process takes time, particularly in a sluggish global economy. The provision of Internet technologies for commerce, industry and public organization

Bursting the Bubble 1198000


Millions ($)



0 2000 B2B B2C 603.7 53.3 2001 1137.6 96 2002 2061.3 169.9 2003 3693.8 285.8 2004 6335.4 454.4


Figure 1. Estimated global e-commerce growth.

was the operating multiplier, or cash ywheel, that sustained the commercial momentum in the early phase of development and initial capital investment. The operating multiplier eect works in reverse when this derived demand falls and can have devastating aects on the demand for capital equipment. Internet rms have suered from these eects because they have been highly reliant on demand derived from industry and commerce (that is, not directly from individual consumers). This derived demand is illustrated in Figure 1, where the B2B market is estimated to be 12 times the size of the B2C market. One of the problems that Internet innovators have encountered is that the existing market has inadequate knowledge and information with which to evaluate and embrace this new technology. As Mowery and Rosenberg12 argue, the market must learn how to accept revolutionary new innovations that fall outside of their present mindset. This appears to have been the case with Internet technology, where much of established industrial management have been slow to adopt the new technology. Furthermore, companies have found themselves having to invest heavily to provide a product (media/ information) with a marginal revenue rapidly approaching zero. However, none of the above factors, or combination of them, can be said to explain the extraordinary overinvestment in the, so-called, new technology sector in the late 1990s, and its capitulation in 2000. Protability is normally considered to be the sine qua non of the rm, and as Koller13 remarks, the crucial drivers of value creation are, therefore, the potential revenue of a company and its capability to translate that revenue into cash ows for shareholders. This ability can be best measured by its long-term return on invested capital. However, by the time the NASDAQ reached its peak in 2000, many nancial analysts were beginning to believe the idea that stock market valuations were no longer driven only by traditional economic factors such as earnings growth, ination, and interest rates. Instead, they began to suggest that new factors such as the value of intangible assets and brands warranted the haughty stock prices. During this time there were just two retail Internet commerce companies that were not over-investing in order to grow, namely, Bay and Yahoo, whilst the rest of the companies, including Amazon, and, spent investors money trying to become big before they became protable, and, with few

120 P. R. Wheal