Lessons Learned

Now that we've had a month to think about it, are there lessons to be learned from last year's tech stock debacle? I can think of a few.

1. Diversification is still important
Although 2000 was a difficult year for stocks, the pain was not evenly distributed. Technology investors bore the brunt of it, with the tech-heavy Nasdaq falling over 39%. The wreckage was even more pervasive in the dot-com world where the median company return was minus 87%. The overall market, represented by the Wilshire 5000 index, fell 11%. However, there were some bright spots. Real estate investment trusts (REITs) rebounded from a couple of down years to gain 26% last year. Unfortunately, there is no way to reliably pick the next hot sector going forward. The smart investor hedges her bets by maintaining a diversified portfolio.

2. Reign in those buoyant expectations
Investor expectations get distorted during a prolonged bull market. Public surveys from early last year showed anticipated annual market returns of 20-30% in the years ahead. In fact, the average annual appreciation of U.S. stocks during the last century was about 11%. After adjusting for inflation and taxes, this number drops well into single digits. While past history is an imperfect guide, there's no better way to forecast future returns. Investors counting on annual returns of 20% and higher are setting themselves up for disappointment.

3. Momentum investing is very risky
Momentum investors believe that hot stocks will stay hot. Although this approach has been effective at times, it can implode with stunning velocity. A better strategy is to invest in broad-market index funds. For those who prefer individual stocks, a diversified portfolio is still the best bet. If you are intent on trying to beat the market averages, an emphasis on small companies and value stocks has done the job historically.

4. Fundamentals matter
Financial economists have been telling us for years that there is a close link between a company's stock price and its economic performance. During the height of the Internet mania, we kept hearing "it's different this time." That is a very dangerous phrase. The dot-com calamity shows that positive cash flow and viable business plans still count.

The above lessons are not meant to dissuade you from investing in technology stocks. The technology sector accounts for about 20% of the overall market and most well-diversified portfolios should reflect this weighting. Your specific situation may differ, depending on personal circumstances.

February 1, 2001

Back to learning Center

Recommended Reading for Investors