Poorer but No Wiser, Investors Remain Captivated by Tech

It is one year later, and with the Nasdaq down nearly 60%, it is difficult to recall all the frenzied speculation that led tech stocks ever higher. The checkout-line talk of fortunes made, the daily litany of new highs, the cheerful young analysts and their price targets, the dream of grandeur that we collectively shared -- it's all a fading memory now, tinged here and there with bits of remorse.

Yet for all that has happened, for all the pain and loss and dreams gone south, America remains obsessed with tech.

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Technology stocks continue to dominate the financial press, and the idea of buying something nontech remains anathema. While a number of sectors have performed well over the past year, the focus is still on somehow sorting the technology wheat from the technology chaff. A typical recent article in a business magazine gets the headline, "10 Tech Trends to Bet On." On a typical recent day on CNBC, fully half of the stocks recommended by portfolio managers are tech. Every day that sees even a mild rally in tech stocks is seen as confirming that the widely discussed "bottom" has been reached.

Investing Disorders?

Sadly, it is not just a media obsession. The online broker Ameritrade lists an index of the stocks its customers are buying and selling, and it is a rare day that a nontech stock makes it onto the list. One recent day the Yahoo! message board for JDS Uniphase (JDSU Quote), the optical-component maker whose stock has dropped 79.3% over the past year, showed 677 posts. The message board for Anheuser-Busch (BUD Quote), which has risen 42.5%, showed six.

Reflective of this compulsion, some investors continue to be so overweight in technology that even seasoned financial advisers blanch at seeing their portfolios.

"I had some clients sign on last week," says Paul Polese, associate portfolio manager at Pinnacle Capital Management. "About five different mutual funds -- all technology and biotech. And all their stock holdings were high-multiple tech companies like Cisco (CSCO Quote), Sun (SUNW Quote). All [had been] bought last March."

It's a hard lesson, but at least Polese's clients have figured out that they made an error by putting all their eggs in one basket and have gone to get their portfolios sorted out. Untold others continue to be hugely overweight technology. Anecdotally, we know that there are many individual investors whose portfolios are more than 70% tech. By comparison, the S&P 500 is about 20% technology. Jeff Applegate, the Lehman Brothers strategist who is one of the biggest tech bulls on Wall Street, carries 26% technology in his model portfolio.

Long-Term Investments Can Make You Blue Early plunge keeps Big Blue lagging behind S&P 500

Source: Baseline.

If such benchmark comparisons don't work for you, Merrill Lynch chief quantitative strategist Rich Bernstein offers another way of determining if you've taken on too much tech.

"If swings in the Nasdaq upset you," he says. "If you lose sleep or you can't work or you're constantly reading the paper trying to figure out what to do and you've got agita because of what's going on, you're taking on too much risk. The day-to-day fluctuations of the Nasdaq should not affect your ability to sleep at night."

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That so many, despite loss of sleep and loss of capital, remain heavily in tech stocks may not be entirely rational, but it is entirely human. First, there is a tendency among both individual and professional investors to hold onto losers. Bernstein notes that a lot of large-cap tech companies have suddenly become "core long-term holdings," when actually, many investors didn't buy them because of some far-off future but rather because the stocks had been adding another 10% every couple of weeks. This is a rationalization, meant to forestall the regret that comes with realizing a loss in the market, which is obviously also a realization that one has been wrong.

Investors' reluctance to admit they are wrong can be very costly. Let's say that you owned IBM (IBM Quote) in August 1988 and kept on holding it even though it hadn't rebounded with the rest of the market after the October 1987 crash. You rationalized this by saying that it was a core long-term holding. Over the next five years, your investment dropped nearly 60%. This came with an incredible opportunity cost, because the S&P 500 gained nearly 60% during that period. Now, IBM turned itself around and its stock was one of the terrific investments of the late '90s. Could one argue that it lived up to its late 1998 billing as a "core long-term holding"? Not at all -- the S&P 500 outperformed it by 98 percentage points over the next 12 years.

Such opportunity costs have already arisen in the current selloff. Although many strategists were lauding consumer staples stocks last spring, many investors remained focused on the elusive bottom in tech, focusing on where they'd seen growth in the past and turning up their noses at things like food stocks. Since the Nasdaq hit its peak March 10, 2000, the S&P 500 food sector has jumped more than 50% -- but, of course, food isn't sexy, and for many investors weaned on the huge gains in tech stocks in the late '90s, food stocks still aren't worth looking at.

Food for Thought S&P food index over the last year

Source: Baseline

"When people invest their lives, their emotions, their hopes in investments, people want to be rich," says Santa Clara University finance professor Meir Statman, who studies investor behavior. "We advise them in our books to be thoughtful, but they really want to win. It comes from evolution. We fight for status -- status comes with resources -- and the stock market is really a place where you can gain resources. This is the great attraction."

The Joneses

One would like to think that professional investors are immune to this kind of thing, that they are happy to just keep hitting singles rather than aiming for the fence. Of course, this isn't the case -- institutional investors are terribly afraid of underperforming their peers, and this can make them go against their own better judgment.

J.P. Morgan equity strategist Doug Cliggott spent a lot of time in the spring and summer advising institutional investors to be underweight in technology stocks relative to the S&P 500, but found that even those who were negative on technology were reluctant to go to anything less than a neutral weight. They were afraid of "benchmark risk": Having seen tech stocks rebound sharply in the past, they were worried that going to an underweight technology position would make them underperform the S&P 500. Never mind that in their heart of hearts they saw better opportunities elsewhere. Even tech bears were afraid of going underweight, as whole institutions remained net-long tech stocks. It was only this fall that institutional investors became comfortable with underweighting tech, and this, says Cliggott, was one of the major reasons for the second wave of selling.

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Source: First Call/Thomson Financial

To this day, many institutions remain overweight in tech. The S&P Barra Growth Index, the benchmark for growth fund managers, was 33% technology at year-end. Large-cap growth funds had a 42% weighting in tech stocks, according to Morningstar. And that continued tech bullishness apparently is not confined to growth funds. "What we're seeing is that fund managers are still quite optimistic on tech, and still like it," says Merrill Lynch global strategist Owain Evans, who conducts a monthly survey of portfolio managers.

What is one to make of investors' continued obsession with technology? For one thing, it calls into question the endless chatter of how tech stocks may be close to a bottom. Typically, people talk of how there has been a surfeit of negativity in the sector, and say it's flushed out all the weak holders. But if U.S. investors remain overweight in technology, it is hard to see how this could have happened. Many bought tech at much higher prices, and many spend sleepless nights hoping for the day the market will bail them out. Meanwhile, the media and Wall Street continue to focus on tech stocks to the exclusion of other investments.

"It reminds me, of the old English sport of boxing," says Bollinger Capital Management head John Bollinger. "They drew a line on the ground, you walked up to that line and put your toes to it. Your opponent walked up and put his toes to the other side of the line, and you beat each other until one of you collapsed. Investors have lined up on one side of the line, tech stocks are on the other side, and they're just beating each other to a pulp."

It may well be that tech stocks won't ease up on investors until investors ease up on tech stocks.