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.