Tag Archives: NASDAQ

Passive Investing and the Risk of Bubbles.

“Passive Investing” has become very popular with investors as some financial writers and the index industry tout the benefits of buying an index fund. It’s said to be the kind of “set it and forget it” investment strategy that appeals to people who have limited investment experience and believe they are doing both the “smart” and “safe” thing.

But there is a downside that people who are not familiar with index funds are not aware of. It’s what happens when an investment “Bubble” breaks.

Legg Mason wrote an informative white paper on this subject recently. We want to quote some of what they said.

The end of a market bubble is never pleasant, but it can be especially painful for investors in passive strategies that track major stock indexes.  A key reason: those indexes tend to increase the weighting of rapidly rising sectors as bubbles inflate, setting up investors for a bigger fall.

When sector bubbles collapse over shorter time periods, the overweights can impact major market indexes as well. Example: as the Internet bubble of the late 1990s collapsed, the weight of the S&P 500 Info Tech sector, one of the ten sectors represented in the S&P 500, shrank by more than half, from 33.3% to 15.4%, as the sector generated a cumulative loss of 73.8%. The same effect could be seen during the global financial crisis, with financials plummeting nearly 80%.

Investors investing $1000 in the very popular index that tracks the NASDAQ market would be investing roughly $120 dollars in Apple, $90 in Microsoft and $50 in Amazon. More than $500 of that investment would go into only 10 stocks. This is an illustration of the fact that the investor who believes that buying an index provides broad diversification may find out that this may not be the case. While buying an index is not necessarily a bad idea, it should be done understanding how indexes are constructed and the amount of risk it involves.

These are only a small sample of the kinds of distortions reflected in passive capitalization-weighted indexes, whose construction forces them to overweight sectors as they become more popular with investors. When added to the well-documented tendency of investors to herd toward supposedly “hot” opportunities, the damage to investment returns can be substantial.

The core issue, however, is not that every success contains the seeds of its own destruction. Rather, it’s that using conventional passive, index-based investing as the center of a balanced investment strategy can introduce unexpected — and unwanted — volatility into a supposedly conservative portfolio, at just the moment when investors may be seeking refuge. And that’s the real trouble with bubbles

The hidden dangers of investing, even in the most common strategies, are just another reason to get professional advice.

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It took 15 years, but the NASDAQ is back.

Fifteen years after it soared to its peak at the height of the dot-com era, the Nasdaq Composite Index cruised to a record closing high yesterday.

In the year 2000, the NASDAQ, driven to ridiculous heights by the technology stock bubble (often referred to as the dot.com bubble) collapsed, taking lots of people’s dreams with it.

A spike in stock prices driven by greed collapsed as people fled the technology sector in fear. As an aside, it provided a great opportunity for those who had the courage and skill to find outstanding bargains amidst the rubble.

The tech bubble of the 1990s is a great lesson in investor psychology. When values are driven by hope rather than by reality, people stop being investors and turn into speculators. The sad story of that time is that even mom and pop investors were caught up in the frenzy. And the collapse ruined many plans and some lives.

We read today about how great index investing is. It cheap, it’s effective and it works … until is stops working. Those who bought the NASDAQ index in 2000, if they had the fortitude to stick it out, would have found themselves breaking even after 15 years of being financially under water.

A good investment strategy always looks at risk. We know that “trees do not grow to the sky” and things that look too good to be true … are not. The first rule of making money is not losing it.

Our investment philosophy is focused on risk control. What that means in real terms is that when the market takes one of its periodic tumbles, it won’t take us 15 years to get even.

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