Lessons From The Past

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Includes: DIA, QQQ, SPY
by: AdvisorShares

Summary

Why is it that index funds are programmed to buy more of a stock after its price increases, sell when the price lowers, and buy it back after recovery?

It was the flaw of indexing that was the biggest reason for the so-called stock market crash of 2000-2002.

Currently, one of the most widely held fears concerning equity investments is the worry that equity markets are overvalued.

By: Brian Evans, CPA/PFS, portfolio manager of the AdvisorShares Madrona ETFs (FWDB, FWDD & FWDI), owner of Madrona Financial Services and Bauer Evans, CPAs

Let me start by making two unremarkable statements. The first: Businesses are in business to make a profit. The second: Buying low and selling high is more effective than buying high and selling low.

I trust this sounds so logical to you that I may lose your attention unless I point out how most investors aren't doing this! The fact is that the largest equity mutual funds on the planet are indexed funds. Why is it then, that index funds are programmed to buy more of a stock after its price increases, sell when the price lowers, and buy it back if the price then recovers? Also, why do indexes have no programming to take into account standard valuation principles such as projected earnings and growth of earnings relative to share price?

It was the flaw of indexing that was the biggest reason for the so-called stock market crash of 2000-2002. In March of 2000, almost 50% of the value of the S&P 500 was in dot-coms, telecom, and technology. Even though more than half the stocks in the index increased in value during this period, too much was invested in those sexy sectors that plunged nearly 80% as a group, leading to a drop in the index "average" of nearly 50%.

Think of it this way, if you only own 5 stocks and 4 of them double in value, can you lose money? Of course you can if you have $1 invested in the 4 that doubled, and $10 in the one that lost half its value.

Currently, one of the most widely held fears concerning equity investments is the worry that equity markets are overvalued. This could lead to a "valuation adjustment" whereby overpriced equities trading at a premium are jettisoned in favor of those trading at a discount. If this were to happen, it's possible that market-cap indexes will suffer. The opportunity would then lie with actively managed, smart beta alternatives with a focus on identifying value in an otherwise overvalued market.

I still don't really understand what happened in the crash of 2008, but I do know the prior crash was preventable in your own portfolios with a large spoon full of common sense by buying low and selling high, instead of the opposite. It's this same common sense that I believe could ward off the next market correction in your own portfolio.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: AdvisorShares is an SEC registered RIA, which advises to actively managed exchange traded funds (Active ETFs). The article has been written by Brian Evans, CPA/PFS, portfolio manager of the AdvisorShares Madrona Global Bond ETF (FWDB), AdvisorShares Madrona Domestic ETF (FWDD) and AdvisorShares Madrona International ETF (FWDI). We are not receiving compensation for this article, and have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: To the extent that this content includes references to securities, those references do not constitute an offer or solicitation to buy, sell or hold such security. AdvisorShares is a sponsor of actively managed exchange-traded funds (ETFs) and holds positions in all of its ETFs. This document should not be considered investment advice and the information contain within should not be relied upon in assessing whether or not to invest in any products mentioned. Investment in securities carries a high degree of risk which may result in investors losing all of their invested capital. Please keep in mind that a company’s past financial performance, including the performance of its share price, does not guarantee future results. To learn more about the risks with actively managed ETFs visit our website http://AdvisorShares.com .