It only took 15 years, but the Nasdaq has finally set a new record high. I always like to say that the biggest mistakes make for the biggest lessons. So, what can we learn from this grueling 15 year round trip?
1) Diversification Works. The biggest lesson from the Nasdaq bubble is the simple lesson of diversification. Having your savings concentrated in one high beta sector of the financial markets can expose you to substantial risk of permanent loss. While the Nasdaq took 15 years to break-even, an investor who owned a 60/40 stock/bond portfolio starting on March 1, 2000 was in the red for just under 4 years. More importantly, while the Nasdaq was clawing its way back to break-even over the next 15 years you generated an annualized return of 5.5%. Not bad for buying in at the peak.
2) Price Compression Creates Tail Risk. I’ve described the concept of price compression as an environment in which investors essentially price in years worth of future returns into a very short time period. Imagine a linear 10 year 8% annualized return line being compressed into a 2 year period. If you have a $100 stock then that stock will get repriced at $215 in 2 years. Of course, the market is forward looking so the market is trying to stay ahead of actual operating earnings. So, if the underlying entity does not actually produce the value that was priced in then this creates a disequilibrium. That is, you’ve got investors who priced in high growth that doesn’t actually come to fruition. And when this is realized the price decompresses. The bigger the compression the bigger the decompression.
When the Nasdaq bubble expanded investors were essentially looking at the potential profitability of the internet and they priced in years worth of profits into a very short period. Loosely speaking, we could say that they priced in 15 years worth of profits in just a few years. And this ties nicely into lesson 1. When you fail to properly diversify you expose yours savings to tail risk events. Price compression isn’t something that should pose a huge risk to your portfolio if you’re properly allocating your savings.
3) Stop Chasing the Next Hot Thing in the Pursuit of Maximizing Returns. If you’re like most people you are maximizing your primary source of income (your real investment) and allocating your savings in a prudent manner that allows you to plan for the future. The goal with your savings isn’t actually return maximization, but return maximization within the parameters of appropriate risk taking. If you’re a real saver who is looking for stability then this means your primary portfolio goal isn’t just protecting against purchasing power loss, but also the risk of permanent loss. And this means accepting the reality that it’s probably imprudent to excessively overweight your portfolio in favor of purchasing power protection.
Unfortunately, most people view the stock market as a place where they will “get rich” and generate Warren Buffet style returns. They tend not to view it as a place to allocate their savings. And this leads to many behavioral biases which lead people to take more risk than they’re actually comfortable with. If you’re a real saver then stop running with the herd into crowded trades in pursuit of a goal that isn’t in-line with your portfolio’s actual goals.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.