The Dotcom Bubble and active investing

What you’ll learn:

• What is ‘market efficiency’?
• The origins of the Dotcom Bubble.
• The paradox of active investing.

One central debate within the investment management industry is the so-called ‘active versus passive’ debate – whether active managers can outperform simple passive index funds, after accounting for management fees.

At its heart, the debate hinges on the notion of ‘market efficiency’ – that markets are priced correctly, so active managers can’t, on average, beat the market. Most people (including us) would agree that markets are unlikely to be perfectly efficient. A perfectly efficient market requires a majority of investors to be rational, such that any mispricing will be quickly acted upon, thus eradicating it. However, time and time again, markets have undergone large-scale mispricing in the past – the Dotcom Bubble of the late 1990s is just one notable example.

Tech-mania

The Dotcom Bubble was a rapid rise (and collapse) in technology stock valuations at the turn of the millennium. Back then, people were just starting to grasp the transformational power of the internet, and technology stocks saw record inflows of money from eager investors who feared missing out on the internet boom. It became possible for an internet company to list on the stock market and raise substantial amounts of money even if it had never made a profit – or, in some cases, realised any revenue.

Throughout this period, technology stock valuations rose to absurd levels. For example, by mid-2000, the price-to-earnings ratio on the well-known tech company, Cisco, had risen to 130 times. For the stock to be priced reasonably at such valuations would have required a near-impossible rate of profits growth from the company. The example of Cisco was merely an indicator of what was taking place throughout the wider tech sector. Fuelled by speculative mania, the cyclically adjusted price-to-earnings ratio on the S&P 500 index itself rose to 50 times by 2000. Similar to Cisco, such valuations would have required significant growth assumptions. The Dotcom Bubble eventually burst wiping trillions of dollars off the value of the stock market, and hitting the value of investor portfolios, not just those who’d focused on tech stocks.

The behavioural challenge

That the Dotcom Bubble occurred at all poses a challenge to the notion of market efficiency. If the stock market is always correctly priced, how could valuations have risen to such unreasonable levels? With hindsight, the reasons driving the Dotcom Bubble are clear: speculative/ fad-based investing, the fear of missing out among investors, the abundance of venture capital funding for startups, and overconfidence in the profitability of tech companies. Interestingly, these reasons closely parallel those of other past speculative manias. They point towards a deeper underlying flaw among human investors, namely, an inability to be perfectly rational.

Over the past decades, studies have repeatedly shown that people are prone to a range of behavioural biases that inhibit rational decision-making. A number of these biases can lead to bubbles, but we’ll just highlight three examples here.

First, people have shown a tendency to over-extrapolate past events. For example, if the stock market went up yesterday, we have a tendency to think that the move will carry on tomorrow. In a bubble, an upward trending market leads investors to buy into the market in anticipation of further gains, thus pushing the market up, and so forth...

Second, people often find it easier to follow the crowd than to go against it. Imagine yourself selling technology stocks as a portfolio manager during the Dotcom Bubble – how long do you think you would have been able to keep your nerve (or avoid getting fired by your investors)? The discomfort from being contrarian can cause investors to ‘herd’, investing in something just because it happens to be the newest fad or is outperforming.

Third, people are prone to confirmation bias – selectively emphasising information that confirms their pre-existing belief. If you are a technology investor during the Dotcom Bubble, it’s easy to give greater weight to reports that only confirm your optimistic views on the sector, while discounting the downside risks (e.g. the sector being massively overpriced, bad business models, lack of revenue, etc…).

Collectively, given the right conditions, these biases can induce the sort of phenomenon like the Dotcom Bubble.

The paradox of active investing

If markets aren’t always efficient – and we think the Dotcom Bubble is evidence of that – it implies that there is scope for some active managers to capitalise on market mispricing, for example, by buying an underpriced asset or selling an overpriced one. However: just because outperforming the market is possible, doesn’t mean that it is easy. For one, it requires investors to push against their own behavioural instincts. Sometimes, it requires the investor to be incredibly patient and tolerant of long periods of underperformance.

Herein lies the paradox of the entire ‘active versus passive’ debate – perhaps it is precisely because active management is so difficult in the first place, that beating the market is actually possible. The very fact that mispricings are difficult to capitalise on, means that there is room for disciplined investors to add value, because not everyone can. After all, if it was so easy, one would have questioned how events like the Dotcom Bubble would have existed in the first place.

How to select an active fund

When considering where to invest, you may turn to a funds list for guidance. Barclays has a tried and tested process for choosing the funds, and the fund managers, that make up our Funds List. Our research philosophy and process has a distinct view on the types of organisations that are likely to create environments for long-term investment success, and we actively seek investment managers that fit this.

Smart Investor offers a wide range of funds, and our Barclays Funds List may help you to narrow down the wide range available to invest in. These funds are selected by Barclays investment specialists and, based on our research, they’re the funds that we believe have the potential to generate consistent returns over the medium to long term.

These funds are designed for the long term so you should only consider them if you can stay invested for at least five years.

All of these investments can fall in value as well rise; you may get back less than you invest.

These are our current opinions but the future, as ever, is uncertain and outcomes may differ.

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The value of investments can fall as well as rise. You may get back less than you invest. Tax rules can change and their effects on you will depend on your individual circumstances.