Nasdaq's teachable moment

Lessons in investing

Fred Taylor //March 30, 2015//

Nasdaq's teachable moment

Lessons in investing

Fred Taylor //March 30, 2015//

You may have heard that the Nasdaq stock market index crossed the value of 5,000 in early March. This event was noteworthy because the last time the index reached a value of 5,000 was 15 years ago.  As our mothers might have said, this is a teachable moment.

A little background on the Nasdaq index will help put this in perspective. The Nasdaq is one of the most widely followed stock market indices. Two of the other popular indices are the S&P 500 and the Dow Jones Industrial Average.

Each of the indices tracks the performance of different parts of the stock market. The Nasdaq has traditionally been made up of more technology companies. Thus it's been seen as a proxy for the technology sector.

Back in the late 1990s, the annual returns on the Nasdaq were huge, as prices for technology stocks raced to the sky.  The value of the index reached its peak in 2000 at a little over 5,000.  It then crashed to about 1,500, and now has crawled its way back to its previous high of 5,000. 

To give you a sense of what this means in real dollars, imagine that you invested $500,000 in a portfolio of Nasdaq stocks in 2000. You would have seen that portfolio decline in value to about $150,000 and then waited 15 years to get back to your original investment.

If you were investing back in the 1990s, you know how hard it was to avoid the intoxicating effects of the Nasdaq party.  It seemed like investors couldn't lose, and technology and the internet were bringing new riches to the entire world.  The professional investing community was also head-over-heels about the prospects of these companies, and devised many new ways to justify overpaying for the chance to be a millionaire.

But if you showed some restraint (it was generally not possible to avoid all of this), you would have saved yourself a lot of heartache and the subsequent suffering through many years of poor returns.

There is a saying coined by Benjamin Graham (a legend in the field of security analysis) that is probably one of the most insightful comments on the nature of stock markets. Graham said, "Price is what you pay; value is what you get." While this sounds simple, it hits at the core of what is most challenging about investing. 

As markets bid up stock prices, investors assume there must be a fundamental reason for it. Contrary to what many investors and salesmen on Wall Street think, Graham recognized that there are many times when price does not come close to equaling value. Yet it takes tremendous discipline to avoid the siren's song of rising prices. 

Just as in 2000, there are companies today that command prices well above what one might consider reasonable given current earnings and realistic growth forecasts.  They tend to be more concentrated in sectors like social media and biotech, although you can find expensive investments in just about any sector.  These companies tend to gather a lot of media attention, as rising prices draw reporters looking for whatever today's market action is.  But media hype and rising prices don't equal investment value. 

Our belief is that there are many opportunities today to invest in good businesses at reasonable prices, and we believe this approach raises the odds that the price we are paying comes closer to the ultimate value we are getting.  In all market cycles, we will gladly forgo some temporary price gains in exchange for higher odds that the wealth we are building for our clients is sustainable.

The 15-year saga of the Nasdaq is a good lesson in how markets can become unhinged from fundamentals when the promise of quick riches is dangled in front of investors.