Nasdaq Underperformance Has Some Concerned

Nasdaq

It’s not that the Nasdaq has hit another bear market or anything, and the 1.1% that this index dropped this week is not even meaningful. The bears are really taking notice though.

People seem to be paying a lot of attention to the Nasdaq this week, given that the other two major indexes, the S&P 500 and the Dow both went up a little, with the Nasdaq losing a little.

The fact that such a thing would be all that newsworthy in itself tells an even bigger story than this little bit of trivia, or the fact that the 2.3% gap between the Nasdaq and the S&P 500 is the biggest one-week gap between the two indexes since 2016.

The real story is about how the Nasdaq beats both these other indexes regularly but hardly anyone seems to notice or care. When we look into this further to try to come up with an explanation, it seems that the penchant so many people have for rooting for underdogs is being used to corrupt a lot of people’s thinking, and their account balances in turn.

We’re not even sure that this gap is a result of worry or their doing a little dance to celebrate the fact that the weaker indexes that they hold instead is having a little moment in the sun. A big part of the reason behind their rooting for underdogs is because they are investing in them instead and are clinging to these investments in the face of their being on the wrong side of the score so often, where they can use these things to try to bolster what should only be considered as false hope, if reality counts for anything that is, and it may not.

We watch these things unfold with an unbiased eye, and anything less than an unbiased view of the movement of stock indexes should strike us as pretty odd actually, even though bias is rampant among many investors. The problem is that so many investors are engrossed in their biases that they do not recognize them as biases, and it might not even strike these people as strange at all how an index could win so many of these weekly matches and build up a huge lead year to date, 17% over the S&P 500 at last count, and see them downplay or even ignore their losses but get so excited over little weekly wins like this.

These biases run deeper than just favoring the S&P 500 over the Nasdaq or value stocks over growth stocks. If we were psychoanalyzing these investors, we’d start by talking about these more superficial biases, but if we go deep enough, to the central problem where the tears start to flow and we really start to understand the root of the problem, it is revealed when they admit that their biases is really against good stocks and in favor of bad ones.

This is where the appeal of rooting for the underdog comes from, and is also where much of some pretty common views of investing come from as well, the ones that actually do manifest bias against performance and bias in favor of underperformance. We talk about this bias quite often, showing how prevalent this view is and how it misdirects so many investors away from the good in favor of the bad to their detriment, detriment that should be far more obvious to them than it is.

These biases are so pernicious that they do not wilt in the face of the most overwhelming of evidence against their soundness, where they will stick to their broken ideas to the bitter end it seems, and the fact that so many investors have preferred the S&P 500 over the Nasdaq year after year in spite of being wrong year after year is just one of a great many manifestations of this investing disease.

The story between the S&P 500 and the Nasdaq goes back much further than just this year, where year after year as well as over the years, the Nasdaq has simply performed better, notably better. In the good times, the Nasdaq has been better, and in the bad times, the Nasdaq has been better as well.

We have characterized this disease as a failure of the normal stimulus-response mechanism that is characteristic of a healthy brain, where in what we are calling a diseased brain, it fails to produce a normal response. This mechanism is omnipresent and is the key to survival for any species, as all creatures need to adapt to their surroundings and select the good over the bad, whether the intervention is by way of a cognitive response or a physiological one.

You don’t really see investor behavior being portrayed as a failure of an appropriate response to stimuli, because you have to be free of this malfunction to even notice it. If everyone raises their fists in victory when the Nasdaq gets beaten by a little over just a week but they don’t know to hold their heads in shame when they are on the losing side or feel anything but continuing hope in the face of the most contrary of evidence, reality can only provide contrast when it is perceived.

If the See the Good is Bad, and the Bad as Good, We’ll End Up with the Bad

We hold the belief that a broader exposure to stocks overall is simply better, even though we really haven’t subjected this belief to any sort of real analysis, which is a big part of the problem and is evidence of the response mechanism being faulty.

To the extent that this is actually the case, if it turned out that going forward, broad exposure actually did produce better investing results, and this happened for long enough that we could be confident enough that the world has changed enough for this to be a trend worthy of placing money on, it may make sense to do this.

In this case, our beliefs and what actually happens, reality, would be aligned in a reasonable manner. We don’t necessarily need good statistical evidence for this claim to want to action this belief, as supporting this claim overall would require that we look at a lot more than the way these two indexes perform against each other and also require quite a bit of time to be statistically valid, but just seeing the S&P 500 actually take over for a good amount of time would be enough to at least show a meaningful trend that we may not only wish to consider, but may be wise to heed.

We do need to be thinking statistically though even though we may not require robust statistical analysis to decide these things, and one of the most important things in advising people how to invest is to keep the analysis well within the means of any investor who is willing to think about their investing a little. Common sense is something that is well within the abilities of even the least sophisticated of investors, and even though some of us may choose more sophisticated modeling, our ideas need to pass the test of common sense first before additional analysis is even warranted.

As it turns out though, common sense is a powerful and invaluable weapon with investing, and its proper use is uncommon indeed. Common sense here only means using the most basic of reasoning skills to direct us, starting with what should be the most basic principle of investing, allowing the goal of making money to stimulate our responses properly.

Where action and reason collide is when we take a certain view of investing and see it fail year after year and not have these failures condition our investing in any way that could be considered sensible, common or not. The Nasdaq versus S&P comparison turns out to be a good example of how dysfunctional thinking can harm us, where so many people think that the S&P 500 is a better place to have our money in, are proven wrong time and again, and refuse to correct their views.

We don’t want to make the mistake of being too presumptuous when it comes to the goals of investors, but we are at least entitled to assume that the assumption that investors seek success with their investments, that doing well with them actually is the goal and they aren’t just accepting lesser performance because they are guilty of higher returns or they just prefer to be less happy.

They say that past results don’t guarantee future results, but they certainly help with predicting them. Investing is surely a game of managing probabilities, with nothing certain, and past results do matter as this is how we vet the future probabilities that we need to understand well enough to bet on one thing happening over another.

Ignoring Past Performance Virtually Guarantees Bad Future Results

The reason why we cite past performance as much as we do is because past performance does mean something, it does provide evidence that we can use to determine the future probabilities that we need to get right to profit from our investments. This is especially important once we realize that stock prices move according to the mood of the market, which is hard to gauge without knowing their mood.

There are reasons behind an asset underperforming another over a meaningful amount of time, like the Nasdaq besting the S&P 500 for so long, and that reason is that the market has viewed the Nasdaq more favorably and is therefore more likely than not to continue to so unless evidence emerges to the contrary, which we will only be aware of if we actually pay attention.

We can go all the way back to when the Nasdaq 100 was born, on September 30, 1985, until today, and compare this with the S&P 500’s performance over this period to get a sense of just how enduring this divergence in performance actually is.

The Nasdaq 100 opened up at 110.62 all those years ago, and now trades at 10,645.22 as of the close on Friday, bad week and all. The S&P 500 was at 183.22 on that day in 1985, and closed Friday’s trading at 3215.57.

A capital return over the 35 years that have since passed of 1,754% is impressive enough, and shows just how much stocks go up over time, with the average annual return over this time being 50.13% simply slaughtering other asset classes such as bonds and precious metals. This is not even including dividends, which would add a bit to this, but given that price appreciation is over 50% a year, a couple of percentage points extra per year in dividends is barely worth mentioning.

The Nasdaq 100, on the other hand, has performed considerably better than this, to the tune of 9,677%, or an average annual return of 276.49%. We don’t need to add in dividends with this one either, which are even more meaningless in this case. This doesn’t guarantee that the Nasdaq 100 will continue to overperform, but given that we need to take a side, it’s just better to take the one that have the odds so much in our favor, if we actually want to win at this game that is.

To say that stocks have had their ups and downs over the last 35 years would be an understatement, but the idea behind long-term investing is not to worry so much about these things, the waves in the ocean we could call this, and there are some pretty big waves that hit us, but long-term investors are looking to not play these waves but to look to capitalize on the massive rise in the ocean itself over these longer time periods. We just saw how much it can go up over this time.

All we really need to get more on the right track is just to observe, and know that bigger numbers are better. There’s your stimulus, but if we ignore it instead of choosing to pay attention, and if we instead attempt to invert reality, where less is more and more is less, we’re not going to do anywhere near as well as we could.

This desire to invert things isn’t just something that happens to some investors some of the time, it is the guiding principle behind the way most people invest, even though they may not be aware of how bad of an investing philosophy this actually is. When so many investors still prefer the S&P over the Nasdaq in the face of the evidence not supporting this view time and again, just because they believe it is better for reasons unexamined, this is not only sub-optimal, it is also sub-rational, and that should bother us to act this way with our financial future on the line.

If you have an index that both regularly beats another one as well as really beating it so soundly over the long term, we’re going to need some strong counter-evidence indeed to call this very long trend over. A couple of percentage points over just a week is comes hilariously short, but if we aren’t using our heads, the joke is on us, whether we get it or not.

Ken Stephens

Chief Editor, MarketReview.com

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.

Contact Ken: ken@marketreview.com

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