History may not repeat itself, but it rhymes.” Mark Twain.Mark Twain.
During October investors in stock and bond markets around the world saw declines in their portfolios, therefore a look at market history may be useful. So far this year, the US stock market has been climbing, fuelled by tax cuts, historic low unemployment and confidence in the economy. The S&P 500 Index, a representation of the top 500 US companies by share capital, is dominated by technology stocks – the so-called FAANGS: Facebook, Apple, Amazon, Netflix and Google. We have been here before. In the 1970s the US stock market index was dominated by the giant oil companies. In the late 1990s, into the new millennium, we witnessed the dot.com boom, with technology stocks dominating.
The study of market history shows that money flows into the market when it is going up, and flows out when it goes down. Most investors are not comfortable investing against the consensus and believe that, if enough people are buying, then the crowd must be right. Unfortunately, the facts show that comfort comes at a high price. Over the six years from 1997 to 2002, the published mutual fund headline data shows the largest technology companies made an average annual return of 1.5%, in spite of the “bubble” and “crash”. A more detailed study shows, that an estimated 72% of capital growth disappeared in the post-bubble break. Investors and their advisors caught up in the momentum of the moment, bought high and sold low.
If this was not bad enough, it got even worse. Asymmetric tax treatment of gains hurt investors, by forcing the immediate recognition of capital gains whilst eliminating the ability to offset with capital losses. The “mean reversion” of equity returns, which means that returns can be very unstable in the short run but very stable in the long run is a fundamental market truth, which investors ignore at their peril.
John Bogle, founder of the first index fund and the Vanguard Mutual Investment Group, states in his classic book ‘Enough’ that Revision to the Mean (RTM) is widespread and “can help us understand financial markets and thereby become more successful investors” (he does not explicitly define the term and it is not perfectly clear whether he regards RTM as an active compensatory process, or a mere failure of persistence). What is clear is that, like Newton’s law of gravity, “What goes up, must come down.”
In the mutual fund world, yesterday’s winners are tomorrow’s losers. While a superficial look at the crash of the overpriced dot.com technology era indicates the collapse of a bubble, simply reversing previous gains, closer scrutiny points to a different outcome. Chasing yesterday’s “hot prospect” and shunning today’s “also ran”, investors lost billions of dollars in technology mutual funds. Buying high on the way up and selling at the lows on the way down is not a formula for investment success.
Jeremy Blatch TEP
This article was also published in the online and print editions of the Sur in English