What Role did Investor Sentiment Play in Creating the Dot-Com Bubble?

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Investor Sentiment: The Rise of the Digital Noise Traders



Figure 1: The NASDAQ Composite Index Pre and Post Dotcom Bubble 
Source: Quartz


The dotcom bubble culminated in the demise of numerous internet-based enterprises, including Pets.com and Webvan, while others such as Amazon and eBay survived the bubble bursting and emerged as industry behemoths. Investor losses during this period were massive, estimated at approximately $5 trillion (source: CFI) by 2002, shown by the downfall of the NASDAQ Composite Index in Figure 1.


The exuberance surrounding internet companies led to inflated stock prices, driven primarily by speculative fervour rather than intrinsic value.


Investor Sentiment Explained, and how this links to the Dot-Com Bubble:


Markets are efficient by definition when investors are rational. However, this speculative fervour mentioned above is one example of non-Bayesian expectation formation. Investors often do not look at the levels of final wealth they can attain but at gains and losses relative to some reference point, which varies from situation to situation but always tends to display loss aversion. One of the most notorious examples of this is the reluctance by investors to sell stocks that lose value.


Investors preferences and beliefs when they are buying securities abide by heuristics rather than a normal economic model of Bayesian rationality. This is known as investor sentiment. Investors whom share these preferences or sentiments are known as 'noise-traders'. These noise traders became increasingly influential within the financial markets due to the ease of information transferring and sharing which was brought alongside the dot-com and internet era. Noise traders are particularly active during high volume trading days and with high volume traded stock tickers, thus with the drastic rise in popularity and price of the internet and tech stocks seen in the late 90's, noise traders were prevalent.


Figure 2: Characteristics of Noise Traders 
Source: Finance Strategists


In short, investor sentiment can be broadly defined as the beliefs and predictions about future cash flows and investment risks without considering the facts at hand.



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