Market Commentary for June(Archive)

Can you believe this bull market in tech stocks? The gains made by the NASDAQ are just eye-popping and yet, still lots of folks still seem so subdued.
In case you suspect we’ve been Rip Van Winkled for the past 15 months let me state the facts: The NASDAQ composite, home to most technology stocks and all things dot.com, has risen from its low of 1639, notched on April 4 of this year, to a high of 2314 on May 24. That’s a 675-point rise and a 41% gain. So why all the long faces?
One answer is that the NASDAQ composite is still down 10% year-to-date. Nobody feels great when they’re underwater and most tech investors clearly are so far this year. But that’s not the whole story. The real answer is deceptively simple.
The NASDAQ fell 68% from its all-time high of 5049 made on March 10, 2000 to its low on April 4, 2001. A 41% rise off its low means we recovered more than half the loss and are down only 27% now, right? Wrong. And therein lies the source of gloom. The mathematics of loss recovery make for a sobering study. Many investors who put all their money into tech stocks in the past few years are making such a study, month after month, as they open their brokerage statements.
If you lose 90% on a stock, sell it and put the proceeds into a new stock that gains 90%, what you have to show, net, for both trades is not a breakeven return. It’s an 81% loss. It takes a 1000% gain to recover from a 90% loss. Do the math. You start with $10 and lose $9. The $1 you have left must gain tenfold to get back to $10.
Similarly, the NASDAQ’s 41% gain off its low leaves the composite down a whopping 55% from its high. That is still a very ugly number, which is what you see on lots of investors’ faces. For the NASDAQ to recover from its 68% decline it will have to climb 308%, which could take a while.
The lesson that thousands if not millions of investors learned the hard way over the past year is that recovering from severe losses is a Herculean task that can take years. And that’s just to get back to breakeven. As old-money types know, the secret to wealth creation is the compounding of returns on a larger and larger capital base over decades. Any severe setback in that capital base can dramatically reduce the magical long-term effects of compounding.
Say you have two portfolios worth $100,000 each that grow for 40 years. One grows 11% each year. The other grows 11% in each year but the 11th, when it declines by 50%. At the end of 40 years, the portfolio that grew a steady 11% per year is worth $6.5 million. The one that grew 11% each year except for one year’s 50% decline is worth $2.9 million.
The moral of this story is that managing risk is as important to long-term investment success as seizing opportunity. Investors who shun diversification in an effort to boost returns often fail to appreciate this crucial truth. Until, of course, that great teacher–the market–takes them to school.