The house-money effect and the snake-bit effect are demonstrated by the demand in 1999 and 2000 for IPOs. IPOs are risky. Many IPOs are companies going public with little sales revenue and signif­icant losses. Because these companies have not been around for very long and have been held by private investors, little information is available. Yet they ask investors to pony up tens, even hundreds of millions of dollars on the expectation that they will grow their rev­enue and eventually make money. The Securities and Exchange Commission (SEC) recognizes that IPOs are inherently risky and therefore does not allow investors to use margin (borrow money) to buy IPOs.

Investor desire for IPOs is a good measure of how much risk investors are willing to take. Experiencing the big returns in 1998 and 1999 (39.6% and 85.6%, respectively, on the Nasdaq composite), some investors may have felt they were playing with the house's money. If so, investing the gains in these risky IPOs would be consis­tent with the house-money effect. Indeed, investors seemed to go crazy for IPOs in 1999. Because of the investor demand, a record 548 companies went public.

VerticalNet, Inc., an operator of business-to-business online trade communities, was a typical IPO in 1999. The company reported a loss of $13.6 million on $3.1 million in sales during 1998 and went public on February 11, 1999. Consider these facts about the offering:

■    Proposed offer price—$12.00 to $14.00

■    Actual offer price—$16.00

■    First day opening price—$41.00

■    First day closing price—$45.38

Before IPO stock is initially sold, investment bankers for the company making the offering conduct a road show to alert investors of the upcoming sale. The bankers advertise the proposed offer price range and get a sense as to the demand for the issue. If demand is low, they will set the price at the lower end of the range. If the demand is high, the price will be set at the higher end of the range. Setting the final price at $16 when the top end of the pro­posed range was only $14 is an indication that they felt a strong demand.

Many investors could not buy the shares they wanted from the investment bankers and had to wait to buy the shares on the stock market during the first day of trading. If many investors are forced to buy the stock on the first day of trading, the stock price will rise. If few investors buy during the first day, the price will fall. VerticalNet started trading at $41—a 156% increase from the $16 offer price! A very strong demand indeed.

VerticalNefs experience was repeated throughout 1999 as investors' demand for these high-risk stocks was insatiable. Over half of the IPO firms earned more than a 50% return for the year. Over 50 firms earned more than 500% in 1999!

Just as the great bull market created house money, the worst year ever for the Nasdaq index—especially the tech sector—may have bit­ten some investors. The Nasdaq composite lost 39% in 2000. The loss was 54% between its peak in March and its low in December. Snake-bit investors recoiled from risky positions. As the snake-bit effect predicts, demand for IPOs dried up. The number of monthly IPOs slowed to a trickle at the end of 2000 (see Figure 6.1)—there were 65 IPOs in August and only 8 in December. Furthermore, there was a change in the type of companies going public. The tech firms with the low sales and big losses were replaced in the IPO market by companies that were already (or nearly) profitable—the IPOs com­ing to market were less risky than before. Investors who have been snake bit take less risk.

THE TECH BUBBLE

This chapter has been about how you view risk. You tend to seek risk or minimize the effects of risk when you have big gains. Alternatively, you tend to avoid risk or overestimate risk after experi­encing big losses. This behavior contributes to stock market bubbles.

The value of a stock derives from its ability to earn profits. The profits from existing operations and the growth of profits in the future are directly related to the company's fundamental value. Companies that generate high profits and growth are valued highly. Of course, future growth is uncertain. Stockholders face the risk of the firm not achieving the expected growth. When companies do not meet expectations, stock prices fall.5

Consider two companies. One is considered to have an excep­tional management team. The other's management has a terrible rep­utation. Which is riskier for you to own? Did you pick the company with the exceptional management or the one with the terrible man­agement? Most people think that the badly managed company is riskier. However, this is incorrect. Since people expect the well-man­aged company to do well, it must perform exceptionally well just to meet those expectations. If its performance is merely very good, it does not meet expectations and the stock price falls. On the other hand, since everyone expects the badly managed company to perform badly, that expectation is certainly not very hard to meet. However, if the company performs just badly (instead of terribly) then it beats expectations and the stock price rises. Therefore, it is not as risky to invest in the badly managed company as it would be to buy stock in the well-managed company. It is not the level of the expectation that moves stock prices, but rather the failure to achieve those expected profits.

Now let's consider the dramatic rise of the technology and Internet sectors in the late 1990s. The prices of these stocks were driven to incredibly high valuations. The high valuations of e-busi­nesses like Amazon.com, Inc., eBay, Inc., and eToys, Inc., reflected outlandish expectations. Remember, these high expectations also mean high risk. How do you react in a market like this? After watch­ing these stocks experience some good gains, you feel the house-money effect and jump into the market and buy some of these stocks. You either ignore or discount the risks. Even worse, you see the high returns generated by these companies in the past and extrapolate those returns for the future. You think the risk is lower because of the high valuations, not higher!

Eventually, the market valuations get too high to be sustained. The bubble pops. When prices plummet, you feel snake bit. Suddenly risk is important to you. In fact, it becomes the most important factor in investing. You do not buy more of these e-busi­nesses. In fact, you want out—these stocks are now too risky to own! The mass exodus out of the stocks drives the prices down, too far in the case of some of the technology and Internet stocks. The expecta­tions of these companies are driven down so low that meeting them should be easy. The risk of these firms is now lower. However, as a snake-bit investor, you overestimate the risk and avoid these stocks.

Of course, you have heard the investment advice, "Buy low, sell high." Why is this so hard to do in practice? One reason is that the house-money effect causes you to seek riskier investments—it makes

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risky because expecta­tions have been elevated too much. In short, you buy high. If stock prices fall, you feel snake bit and you want out, so you sell low. The combination of the house-money and snake-bit effects causes you to do the opposite of buying low and selling high. If many investors behave the same way you do, the entire market can be affected.