The pillars of disciplined portfolio construction are proven again and again in many market environments. This approach uses research in order to identify how to create long-term value. The research shows that diversification, staying the course and setting an appropriate strategic asset allocation (to reflect your risk) produces consistent long-term results.
But while this body of research grows using data over all sorts of market periods, there is a human temptation to look for the next hot stock, investing trend or great idea that will lead to even greater riches. The idea of greater riches is an emotional one, not a scientific one, and typically cannot produce a better return. Even more important, it forces you to take on risk that you may not even realize you are assuming.
So what new and exciting investment approach is enticing investors during this period of time? Technology stocks — and the idea that this group of investments will provide dominant investment results.
Technology stocks are often looked at by those responding to the emotional lure as an alternative to some of the diversifying asset classes in your portfolio. You should ask some questions when thinking about technology stocks as bright, shiny investments:
- Is it “new”?
- What is the impact to your overall portfolio of holding these investments instead of a broadly diversified portfolio?
- What risks are you assuming?
Technology stocks: A new investment idea?
We all feel like technology is new and cutting-edge. We are in a pandemic. Technology stocks offer a new vision for the future. They are indeed bright, shiny things. Has this happened before? Yes.
Technology is not a new story. And it is not a story without setbacks. Technology stocks have experienced some significant ones. Will their value continue to hold in whatever market conditions come next? Do they offer similar diversification or risk for whatever they are replacing in your portfolio?
Let’s review some history of market performance for technology stocks, since this is not the first time investors have been captivated by this investment idea.
The dot-com bubble: Technology in the 1990s
The dot-com era in investing was growing through the 1990s. New firms were starting. Valuations were being adjusted to compensate for the longer earnings cycles of the tech startup, and investors were anxious to invest in these companies.
Truly, I had a taxi driver tell me that these stocks could not possibly go down, and he went on to express his frustration that he could not buy them on 100% margin (essentially by offering no collateral). It proved to be rather lucky for him and kept him from getting in much more trouble when technology stocks did indeed go down. As unusual as that anecdote is, it was the prevailing attitude in 1999.
Technology stocks performed well through the 1990s, and their cumulative return from January 1995 through February 2000 was 42.59% as measured by the NASDAQ Composite.1 At this point, the dot-com stocks were very much bright, shiny objects, and investors were eager to write new investment rules and take additional portfolio risk to purchase them.
And equity markets continued to rise across the board, reaching an apex (of this era) on March 10, 2000. Between March 10, 2000, and October 4, 2002, the NASDAQ Composite experienced a cumulative decline of 77.4%! (This decline was -43.9% on an annualized basis. Still shocking.2) Of course, everyone thought it would continue forever, much like the big tech stocks of today.
It was a dramatic turn, as you can see in the chart below, which shows NASDAQ composite performance from March 10, 2000, through October 4, 2002.
Source: Morningstar Direct. Data as of August 10, 2020. The chart represents returns of the NASDAQ Composite Price Return (PR) USD Index between March 10, 2000, and October 4, 2002. The index is market-capitalization weighted and measures the performance of all domestic and international based common type stocks listed on the NASDAQ Stock Market.
As bright and shiny as tech stocks appeared to be, this chart shows what lay ahead for them and for the portfolios of those who emphasized those investments at the expense of more diversified asset classes.
The go-go stocks of the 1960s
As much as we think that tech stocks are new, the go-go stocks of the 1960s contained a lot of exposure to technology stocks as well. For those of you too young to remember the bright, shiny stocks of this era, they include securities like Polaroid, Telex, Control Data, Teledyne, Texas Instruments and Itek.
Indeed, the annual market growth looked great through much of the 1960s, with several banner years posting annual returns greater than 20% (as measured by the S&P 500), including 1961 (26.88%), 1963 (22.76%) and 1967 (23.89%). Note that in those same years, the Dow Jones Industrial Average (the standard index at that time), posted good returns, but never exceeded the 20% mark, when reviewing the Price Return index.3
But for all of those early tech investors jumping in to the go-go stocks, the risk was soon apparent. The U.S. entered a recession in 1968, which continued into the 1970s and was worsened by the oil crisis coupled with very high inflation. The stock market was down until 1975. It was another extended period of poor market performance, including the bright, shiny go-go stocks.
Where is the risk in switching a portfolio to something bright and shiny?
Are tech stocks bad? No, of course not! And they are part of a diversified portfolio. But the challenge of the emotional draw to investments such as this is that you usually disrupt your balanced and diversified portfolio to overweight them. When you change the overall portfolio risk, it may be at a time when you need the protection of diversification the most.
Increasing risk by shifting holdings
What happens when you are emotionally drawn to a bright, shiny investment idea such as today’s tech stocks? To be able to purchase them means you need to raise some money to make the investment. By selling an asset in another asset class (it might be value stocks or international stocks or fixed income) to make the purchase, you shift your asset allocation. Your portfolio is now less diversified and therefore riskier than it used to be. Did you intend to take more risk? Likely not. It is one of the unintentional side effects.
The risk of reducing diversification
One of the key benefits of a broadly diversified portfolio is that the assets you hold will perform differently in different markets. So if the U.S. equity market goes down, the portfolio also holds assets that may go up and some others that won’t go up or down. This protects your portfolio during market volatility. By reducing these diversifying holdings in your portfolio, you lose that protection in a more turbulent market environment. Avoiding the hidden temptations of a bright, shiny investment will keep your protection in place via holding a diversified portfolio in volatile markets.
The true path to long-run expected returns
The real value in your portfolio is holding a broadly diversified set of stocks and bonds (U.S. and international) so that you have balanced exposure and protection. This controls your risk level and provides you the highest long-term expected return.
The reason diversification is so important is because it protects you in volatile and changing markets and provides the greatest value in the long-run — which should be far greater than the temporary allure of the bright, shiny investment of the moment.
Gain confidence in your financial future
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