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EXPERIENCING RISK: A LESSON IN INVESTING
RISK (Webster's Def'n.): the chance of injury, damage, or loss; exposing oneself to a hazard.
by FRED MIDDLETON, General Partner, Sanderling Ventures.
The economic expansion and bull market of the 1990's lasted almost ten years - long enough that many investors playing the stock market had never experienced a real "Bear Market" - when stocks head significantly lower for a prolonged period of time. Many investors who owned shares in the stock market by 1999 had not invested long enough to experience (or their memories were not long enough to remember) the downside volatility associated with investment risk.
Restructuring the "Old Economy"
The bull market started sanely enough. By the end of the 1990-91 recession, corporate America had finished a long period, begun in the 1980's, of restructuring their assets and costs, downsizing, and becoming more efficient. Many traditional larger firms including the pharmaceuticals, automobile, office equipment, energy and financial services all trimmed payrolls and made themselves more efficient in terms of sales dollar per employee. The result was a leaner, stronger group of "Old Economy" companies, which focused on specific products and markets, and a pool of corporate workers who understood the importance of being flexible and able to adapt to a changing economy.
Enter the "New Economy" and the Rise of Technology Investing
The early 1990's saw an amazing confluence of new technologies come together to achieve "critical mass" in the marketplace. These included the widespread adoption of standardized software (Windows); PCs on every desk top at work, school, and home; a huge increase memory available to these systems; the digitization of nearly all written materials, records, pictures and media to make them available on computers; and the rapid proliferation of the Internet connecting all these computers and their users, together. At the same time connectivity increased through the rapid spread of wireless communications which made the personal "communicator" possible. Practically everyone carries a cell phone today. These technology-based changes occurring in the last ten years have profoundly impacted the way we work, live, and communicate. To commercialize this cornucopia of technology products, the available labor pool from corporate downsizing together with a new generation of young techno-wizards landed in new jobs and began participating in the "New Economy" driven growth of new job creation in the 1990's. The implementation of technology products and systems by American business resulted in an investment capital-spending boom for building these new generation of products and their supporting infrastructure. Companies and consumers embraced all kinds of technology solutions. Soon, the annual growth of productivity of U.S. workers reached levels not measured since the 1960's, allowing inflation and interest rates to remain low. The economy turned in year after year of steady growth - the stock market responded with increasing investor interest and rising stock prices.

Sector Market Cycles and Duration

Electronics/IT

Years Up-Cycle Duration Percentage Appreciation

1966-69 3

1978-83 5 +350%¹

1992-00 8 +700%¹

Biotech/Biomedical

Years Up-Cycle Duration Percentage Appreciation

1988-93 5 +410%³

¹H&Q Tech Index
³AMEX Biotechnology

Investors Always Love a Good Story: Stock Market Enthusiasm Builds
The Internet captured the imagination of America and investors. "It will be bigger than radio and television," predicted one leading Bay Area venture capitalist. Investments in new technology firms by venture capitalists increased dramatically, fueled by the initial big early successes by investors

First-Year Aftermarket Performance of U.S. IPOs

in companies like Cisco, Yahoo, E-Bay and others. Stock prices rose steadily higher, year after year. If stock prices dipped for a week or two, investors would step up and "buy on weakness," taking advantage of temporarily lower prices. Increasing stock prices started looking like a "sure thing." A voracious appetite also developed from public investors eager to buy new companies funded privately by venture capital and now ready to "go public." Soon, every technology and Internet stock with "dot-com" or "network" in the name seemed to be highly sought after. Investors unable to buy scarce IPOs began bidding stock prices higher in the aftermarket. In 1999, the average IPO increased over 300% within one year of the offering! These unprecedented market returns began attracting exorbitant amounts of capital from new investors eager to play.

Private Equity Flows To Startup Companies in the Internet, IT, and Biomedical Sectors

Investor Return Expectations Increase to Speculative Levels
Investors regularly began expecting to earn returns of 25-30% per year, which were considered "average" and "low risk." (Although this was unprecedented historically.) Anyone, it was thought, could buy stocks and earn these returns. Aggressive investors, who spent more time on their computers, expected to earn more: "triple digit" returns (over 100% per year) were possible. These "day traders" often quit their regular jobs to trade stocks in order to double or triple their compensation over their regular salaries. In this frenzy, investment rationales for funding companies and buying their stocks became less analytical and more a matter of blind faith, or the latest stock tips from CNBC. Thousands of firms were started and funded by investors without rational business models capable of achieving commercial success in a reasonable amount of time for a reasonable amount of money.
Paying the Piper By Ignoring Risk
What was wrong with this picture? Investors increasingly failed to consider the level of Risk they were exposing their capital to in order to pursue these very high returns. The prices achieved by many stocks bore no relationship to any rational measure of the value represented by the

Financing Round Valuations Increase as Additional Funds Enter the IT Sector

underlying businesses. In fact, it is likely that many investors understood little about the companies they had invested in. Things had progressed to the point of the "Greater Fool Theory." In other words, nothing really matters about the price of a stock you bought or the company behind it other than whether or not you believe a new buyer (the Greater Fool than you) will come along and pay you more so you can make a profit on your investment. Such reasoning is, of course, no more than speculation and gambling. The Risk of losing your capital at this game at some point becomes very high, if you keep playing.

Stock Market Bubble Forms At the End of the 1990s Bull Market

A Speculative "Bubble" Formed at the End of the 1990's Bull Market
In March 2000, the euphoria peaked, stock prices rocketed up for a final big rally, and then, the sellers started to out number the buyers and the bull market of the 1990's was over. Stock prices began their long march downward. Trillions of dollars in paper value began melting away. A whole new generation of investors began to experience the reality of investing's silent partner: RISK. The technology revolution of the 1990's and the real economic growth which occurred because of it were real enough. So were the excesses of the careless overinvestment and speculative risk which accompanied it.

My Stock Portfolio

Cartoon included in article