If you spend any time around the investing world, you've surely heard the old proverb that investors (not the ones saying it, of course) are an emotional bunch who overreact to everything. When the market shows signs of weakness, they run and run fast. When it shows strength, they close their eyes and throw money at it with little regard for logic and without a sound, disciplined approach based on due diligence. The dotcom boom is a fine example of this foolish exurbrance, but there's reasons to believe that social media's recent rise won't share the dotcom companies' fates. (To read more about fads, check out Investing In Fads.)
TUTORIAL: Investing 101
The Dotcom Bubble
Very few events in our recent history highlight illogical investing as well as the dot-com bubble that we saw in 1995 to 2000. The internet was a new technology that had very little commercial use. By 1995, the modern day technological Gold Rush was quickly taking over. Speculators - investors willing to commit large amounts of capital to unproven ventures - were throwing money at anything having to do with the internet.
While some ideas were promising, others were not. Some ideas were nothing more than an idea. Often, no company was ever formed and if it was, the valuations of some of these extremely small businesses were inflated to astronomical proportions and the technology sector as a whole was rapidly rising in value without much regard to market fundamentals. (To learn more about a bubble, see 5 Steps Of A Bubble.)
The Nasdaq Example
Take the Nasdaq, the stock index largely made up of technology stocks. In 2000, the high point of the dotcom bubble, the NASDAQ topped out at 5132.52. If you don't follow the stock market closely, that may not seem too shocking but consider this: 5132.52 represents a 570% increase in value from 1995.
If you would have invested just $1,000 in to the dotcom bubble in 1995 and then later got out on the day of the peak, your $1,000 would have $5,700. Multiply that by the millions or billions that venture capitalists were throwing at this bubble, and it's easy to see why big money managers were in a technology euphoria and not too worried about the underlying fundamentals of these companies.
What goes up will always come down if given enough time and that was especially true of the dotcom bubble. When the NASDAQ crashed in 2000, investors lost a lot of the money they made because the bubble wasn't largely based on sound fundamentals. Companies lost all funding at an alarming rate and few survived. Only a select few, like Amazon.com, and Google, survived. More than a decade later, the NASDAQ sits well below 3,000, a fraction of its dotcom level. (To read more about the markets, read The NYSE And Nasdaq: How They Work.)
The Rise of Social Media
Is history beginning to repeat itself? Investors are once again excited over technology. Take social media, for example. 72% of all internet users are members of at least one social networking site and for most, the site of choice is Facebook. Twenty-four of the 25 largest newspapers have experienced declines in circulation largely attributed to social media, and maybe the most astonishing, users of social media sites log in an average of twice per day on social media sites and only nine times per month on all other sites.
Currently, Facebook isn't a publicly-traded company but recent valuations in January 2011 value the popular social media website at $83 Billion. Compare that to Amazon.com's valuation of $77 Billion.
Twitter, the most popular microblogging site in the world, is valued at $8 to $10 billion and is also not publicly traded. With Twitter's 2010 earnings only at $45 million, that gives it a valuation of more than 100 times its current real life revenues. That's a big premium to pay to have a piece of this company. Think of it this way: Let's assume that you were one of the brightest minds in your field and last year you made $1 million. If people valued you the way they value Twitter, your worth would come in at $100 million! (To learn more about valuing a company, check out Equity Valuation In Good Times And Bad.)
Why It's Different
Banking firm UBS (NYSE:UBS) does warn that cloud computing may be exhibiting signs of a bubble. However, UBS also says that it may be different this time around. Companies like Facebook and Twitter offer a real, technologically-mature product to customers. They are tangible entities who are changing the way we use the internet. Cloud computing is leading the way in changing our computing habits. Even more significant, cloud computing requires massive data centers which generates real sales and revenue for other tech companies.
Finally, UBS says that this time around the entire technology sector isn't appreciating at an unsustainable rate. Instead, certain companies may be exhibiting these signs and although they may have bubbles of their own, it probably doesn't pose systemic risk, an event that affects the entire stock market. (For a little help identifying solid opportunities, see 5 "New" Rules For Safe Investing.)
The Bottom Line
It's easy for us to look back at the dotcom bubble and see the errors of our ways, but it is much harder to look forward with truly sound judgment. Possibly the best way to judge the quality of an investment is to remember that the best investments are time tested. They won't generate a 570% gain in five years, but over the life of the investment they will be a source of great revenue. (To read more on risk and reward, read Determining Risk And The Risk Pyramid.)