To colorful, delicate bubbles of 2007, 2008 and beyond

bubbleThere have always been bubbles. There will always be bubbles…”

And thank god for the bubbles!

Judge Posner, one of the figures I admire the most, has written a very insightful piece on the Subprime Mortgage crisis, but the part that grabbed my attention was his eloquent description of how bubbles form.

A bubble begins when prices, in this case of housing, begin rising at a rate that seems inexplicable in relation to demand. No one knows how high they will rise. In conditions of uncertainty, there is a tendency to base expectations on simple extrapolation: if prices are rising, they are expected to continue to rise-for a time, but no one knows for how long a time. There is a reluctance to act as if they will not continue rising, for by doing so one is leaving money on the table. As a bubble expands, the rational response is to reduce risk, without forgoing profit, by getting in and out of the market as quickly as possible. The increased trading may keep the bubble expanding.

His observations and reasoning about how the housing, and subsequent investment bubble, got created are equally applicable to the web 2.0 properties and explains the valuation of many of the companies that we see around us. I have marveled over the valuation of Geni ($100M) and Tagged ($117M) and Facebook ($15B). In 2007 we saw the valuation of these companies rising at a rate that seems somewhat inexplicable.

Judge Posner also notes that the Bubbles are more likely to occur when downside risk is less than upside risk. In the Tech word, because the potential of “up side” is perceived to be very high, (e.g., Peter Thiel’s 500k investment in Facebook turning in to 1B+), the valuation of many Web 2.0 companies gets skewed.

But at the same time, as Judge Posner notes that even with the valuations that may seem skewed or inexplicable, it is not the time to walk away from the deals. The optimal thing to do might be to extract the up side from the expansion of the bubble. If the valuations of the start ups are rising, they are expected to continue to rise-for a time, but no one knows for how long a time. The bubble will continue to get fed and will continue to grow during this time. Hope you are participating in that growth.

There is a lot to be done over the next few years; open social, always on connection, moving office products to the web, more touch screen gadgets - and more specialized applications for the touch screen gadgets, HDTV, higher quality audio, DRM free music and each of these fields will spawn new startups, new Googles, and new Facebooks. There are opportunities abound and I hope the right one knocks at your door in 2008.

Happy New Year!

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