WE HAVE recently passed a noteworthy anniversary.Not a happy one, but one which is worth some reflection. On 10 March 2000, following an unprecedented stock market bull-run, the Nasdaq Index hit its peak of 5,048.Most market commentators cite this as the day the technology bubble burst, and the start of the ensuing bear market. The Nasdaq fell a painful 80 per cent, and although it has recovered somewhat since then, at the time of writing it stands at 2005.
There were warnings.In 1996 Alan Greenspan cautioned that we were living in a time of “irrational exuberance”.He repeated his concerns on 6 March 2000, along with the head of the US Securities and Exchange Commission, Arthur Levitt, who urged:“these times of unprecedented opportunity and change also demand greater vigilance from investors… The greatest threat to continued prosperity is a loss of perspective… More than ever, investors must remain focused on what makes sound investing sense for their families, for themselves, and for a more financially stable future.”
One reason people did not listen was because there was some foundation to all the hype. Internet technology was developing in leaps and bounds and billions were spent on technology in anticipation of the millennium bug.Everyone was talking about how technology stocks were rocketing up and this was supported by a booming economic and business environment.Many claimed we were living in a ‘new economy’, one which would continue to rise.
With the benefit of hindsight commentators have analysed why the bubble formed and burst.Today, though, I don’t want to reflect on why it happened, but simply that it happened. The lessons may have been painful, but it is important to learn them. It is also sensible when looking at such happenings to remember that in stock market terms… what goes down will go up.
First of all, market cycles do exist.In the late 1990s some claimed that except for the odd hiccup the economy and markets were headed ever upwards.
Likewise, trends do end.Six years ago some saw the dominance of the technology equities as virtually an eternal trend.But it crashed and confidence in it remains low five years later.In 1999 few would have predicted that property and fixed interest would become the next best performing assets.
At the time many believed that you only needed to invest in equities.The ‘irrational exuberance’ led many people to ignore bonds.However, recent research by Barclay’s Capital conclusively showed that while equities strongly outperform bonds and other assets in the long term, over the last decade, UK equities produced a real return of 5 per cent; gilts returned 6.5 per cent and corporate bonds a healthy 8.5 per cent. Another lesson is that risk and return are related.In 1999 many were acting as though equity investment was risk free.Many investors were so tempted by the returns that they forgot to consider the risk element and that higher returns come at a price.
The downside of these lessons is that many investors have become obsessed with risk and are still very wary of equities.They prefer to stick to cash, or follow a new trend: the perceived safety of property.They ignore inflation or forget that property is an investment asset which can be subject to a bubble.In fact, the way people have been talking about property the last few years is similar to how they talked about technology stocks in the late 1990s. There is a solution.It is the most important lesson we can learn from the 2000 market crash, and is the answer to Levitt’s recommendation to “remain focused on what makes sound investing sense for (your) families, for (yourselves), and for a more financially stable future”: Diversification.
Diversification – spreading your money among many different investments – takes a middle road through the highs and lows of market performance, allowing your money the opportunity to grow regularly with fewer fluctuations along the way.
The reason for diversification is simple: by including a variety of investments in your portfolio, your risk is less than if you put all your money in one type of investment.
Because investments react differently to market conditions and other factors, it is advisable to keep a well-diversified portfolio in order to balance out the ups and downs. Though you are not as likely to make a killing, you are protecting your savings from short-term losses and allowing them the opportunity to grow over time.
Diversification can be achieved in two ways: within an asset class (such as equities) or across asset classes (such as equities and bonds). In the first case, you are likely to have smaller swings of value over time in a portfolio that holds equity in a dozen different companies instead of one. You are likely to have still smaller swings of value if you add fixed-income investments, such as bonds, to your portfolio.
Diversification helps balance risk and return.It also prepares you for the start of new market cycles and trends, and helps protect your overall portfolio when they end.It takes discipline to stick to these principles, particularly if the rest of the world is convinced that a new trend is here to stay.But if you apply that discipline, you will be more effectively positioned for the twists and turns that lie ahead.
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By Bill Blevins,
Financial Correspondent,
Blevins Franks
International Limited
