AI Bubble & Dot.com Era – Revisit : Behavioral Finance and the Financial Markets
There is a mania in the US financial markets with selective AI equities; any stock sprinkled with AI “Pixie Dust” can cause a “rally to the moon” (jargon taken from Reddit Trader during meme stocks boon). The concentrated AI bubble in selective mega tech is nothing new; examples from the past include the Nifty Fifty stocks of the 1970s to the Dot-com bubble. During the dot-com bubble, any company that added “.com” to their name saw the stock of that company go on hyperdrive elevation. Examples are numerous, but one that stands out is Pet.com, which shot up to the stratosphere only to come crashing down after the bubble burst.
I’m not implying that the situation is identical here to the 2000 dot-com bubble, but there are still many similarities and as Mark Twain once famously said, “History doesn’t repeat itself, but it often rhymes”. Coming from a technology background, my opinion is that AI is both a revolutionary and evolutionary technology. AI is nothing new; it’s just further code automation, with machines learning on large datasets called LLMs (Large Language Models) and outputting responses through generative AI. Just like the internet phenomenon changed our lives over the years, AI will likely do so too, but again, it will be over the years and possibly decades.
Currently, semiconductor (hardware) providers such as Nvidia (GPUs) and Super Microcomputer (Servers) are selling equipment to cloud providers such as Amazon, Microsoft, Google, and Oracle to build capacity, but there are few applications such as Microsoft Co-pilot and ChatGPT. Applications will come and evolve over time, very similar to what happened back in the dot com era where equipment providers such as Cisco Systems, Dell, and optical cable providers sold tons of capacity, and their stocks declined significantly after the bust, with applications that some of us use today coming much later. AI technology is still in its nascent form and will evolve over time.
The US market has been in overdrive since March of 2009. The housing/banking crisis of 2008 slammed the S&P 500 by more than 50%, dropping it to the spooky number of 666 on March 9th, 2009. Since then, it has risen by 650% to the current levels of the S&P 500 at 5000. Valuations and risk-taking are overextended for certain mega-tech stocks, with the S&P 500 currently trading at a 21 multiple versus an average multiple of 16. These valuations can remain elevated for extended periods; the internet bubble lasted from 1995 to 2000 before crashing and bottoming out until 2002. Only time can tell when this hype is over; for that, an article written on behavioral finance is the order of the day! Enjoy and please comment.
Behavioral Finance and the Financial Markets
(Originally this blog was written in 2010 republished in 2022, I’ve modified and reposting it due to recent conditions in Financial Markets)
Behavioral Finance is a sub field of Behavioral Economics that mainly deals with human psychology as it pertains to Investment decisions. Here in this blog my attempt is to bring educational awareness and understanding regarding this topic and to explain why it matters in investment decisions.
Per Investopedia, the definition of Behavioral Finance, “Psychological influences and biases affect the financial behavior of Investors and financial practitioners”. In simple terms, it’s a study of human emotions and how it impacts an individual in making his investment decisions. Therefore, at the height of panic or fear in the financial markets, an average investor may sell his investments at a significant loss just because everyone else is selling, his fear overcomes his rationality of making prudent financial decision. This behavior was observed during the market bottom in March 2009/2020. Similar but opposite situation would be that of at the height of exuberance or over confidence; an investor may buy an asset just because everyone else is buying, and in this case his overconfidence overcomes his rationality of making prudent financial decision, for example, buying and flipping houses during the Real Estate bubble of 2008 or buying meme stocks in 2021. Investors make bad financial decisions when they are in an emotional state and follow herd mentality.
Herd mentality is the psychology of an investor to make decisions with limited information and follow other investors just because it’s a trend or fad. It’s an event of hearing exuberant stories of typically high risk and high rewards of others and then attempting to replicate it by taking the same high risk in order not to miss out on the opportunity. Recent example is the investment in meme stocks, such as GameStop Corp. where Reddit traders and investors piled up to elevate the stock price to unprecedented levels with few knowing how terrible were the fundamentals of the company which was on the verge of bankruptcy. Another recent example is that of Bitcoin and crypto currencies, where retail investors along with sophisticated Wall Street gurus got on the bandwagon of elevating the Crypto currencies prices without much understanding of the fundamentals, this was all not to miss out on the opportunity and delusions of making a fortune, shows sometimes even the sophisticated professional money managers are not immune to the herd mentality.
The final part of this blog is about stories, in their book “Animal Spirits”; authors George Akerlof and Robert Shiller state that “the confidence of a nation, or any large group, tend to revolve around stories. They further quote Roger Schank and Robert Abelson, that storytelling is fundamental to human knowledge. For People, memories of essential facts are indexed in the brain around human stories. It’s observed that when people do well financially, they tend to get excited by telling their stories of good fortune, which impacts others to follow similar path and attempt to gain success and make their own stories and that in turn spreads on as new stories. I’ll also mention a story that I read some time ago, about a group of people taking shuttle service to a Las Vegas casino, where on the shuttle the people were told phenomenal success stories of making fortunes in the casino through gambling but no one talked about the phenomenal losses incurred in the casino. Similarly, in extreme panic or fear mode, people tend to forgo opportunities as the pain from losses is too great, this is observed right when the pessimism in market is high and investors get overly cautious.
Most of the financial bubbles are formed due to overconfidence, herd mentality and following exuberant success stories of others. There is saying by a legendry investor John Templeton, “Bull markets are born on Pessimism, grown on skepticism, mature on optimism and die on euphoria”.
Here are some books that I recommend to read on this subject.
Animal Spirits by George Akerlof and Robert Shiller
Fooled by Randomness by Nasim TalebHeader four