The Hindsight Fallacy

The recent sky-high IPO of LinkedIn, along with eye-popping valuations for other social networking and shopping companies, has raised concerns that we are now in the midst of another technology bubble, this one fueled by excessive investor enthusiasm for all things social.

No sooner have these concerns been raised, however, than they have been countered by an array of arguments, all of which are variations on the basic claim that this internet boom is unlike the previous one. This debate illustrates one of the central causes of financial bubbles: Although after the fact it seems obvious that prices were irrational and an unhappy end was inevitable, bubbles are neither obvious nor inevitable at the time.

The fact is that financial bubbles throughout history display almost metronomic regularity. Some asset class, often a product of new technology or financial innovation, becomes fashionable, and prices rise rapidly as demand outstrips supply. Excitement over early riches leads to speculation that the normal economic rules have changed, thereby justifying valuations that are based largely on assumptions about future profits. As prices balloon well beyond early investors' wildest dreams, disagreement over the correct measure of value increases. Then, finally, some adverse event that might normally have little impact triggers a downward spiral of selling, often accompanied by outright panic.

In hindsight, this pattern is so familiar that it's hard to believe anyone could have misunderstood what was happening—witness the now-ridiculous-seeming valuations of the 1990s Internet start-ups, and more recently the clearly misguided assumptions about perpetual growth in real estate prices that underpinned the 2008 financial crisis.

But if bubbles are so obvious, why do they keep happening?

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