Lessons from the decline in technology stocks: investing and portfolio strategies to reduce pain and risk

The year 2000 turned out to be an educational year for many investors. Unfortunately, it is usually pain that causes lessons to sink in the deepest, and hence be remembered longest.

The Nasdaq stock market index represents the best high-tech stocks in the U.S. Near the end of 2000, the Nasdaq Composite was down more than 50% from its previous high in the spring.

What are some of the lessons that investors can take from this painful decline in tech stocks?

Buying high is risky. Everyone knows to "buy low and sell high." But with our focus on short-term historical results, it is difficult to not want the same returns as a neighbour who gained over 100% last year. Unfortunately, buying something after it has had spectacular returns means there is little room to rise further, but there is a long way to drop to get back to reasonable valuations.

Buying volatile, high-tech equities with borrowed money is very risky, and runs counter to conservative leverage.

Investors eventually behave (more) rationally. While group behaviour can drive prices to irrationally high and low levels, valuations do eventually average out to historical levels.

Buying low is more profitable and less risky. Value investors who buy when investments are down have less downside risk, and have more upside potential.

The challenge is defining what is "low" and "high." One approach fund investors involves buying more when a fund is down by at least 10%.

Rebalancing your portfolio to maintain the desired ratio of asset classes automatically buys more of what is low and sells some of what is high. For example, if your goals and risk tolerance are met with a portfolio of 70% equities, 20% bonds, and 10% cash, then make annual adjustments to get back to those ratios.

Profits do count. During the early stages of the dot-com mania, it wasn't even necessary for a company to have much revenue, let alone profits, to be worth billions of dollars. Finally, investors are realizing that it doesn't matter whether you sell books or wireless communication systems, a business is a horrible investment if it doesn't produce profits, and in a timely manner.

Diversification is key to reducing risk. Buying five high-tech stocks is not diversification. To reduce risk, especially short-term risk, you must diversify by asset class, having some equities, bonds and cash.

Equity investments should be diversified into several industries. Diversifying your mutual funds with several different management styles (value, growth, momentum, etc.) can also reduce risk.

Technology will clearly be a major part of the global economy of the future. Patient investors can benefit with less risk by buying more when the Nasdaq Composite is below 3,000 than when it is above 5,000.

COPYRIGHT 2001 Money Digest
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