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The blistering rally in technology stocks since equity markets bottomed out in October 2022, is becoming a serious dilemma for traders. For those who dumped tech stocks in 2022 but failed to catch the market bottom, they will have to decide between playing
Perhaps we are exaggerating the challenges that traders face trying to time the market day in and day out. Surely, most traders would have some kind of strategy in place to facilitate quick decision-making, or a favourite indicator to help decipher where the market is headed
But for those who have tried to time markets and failed, it might be worthwhile to question if all that precision associated with short-term trading is even necessary. At the very least, aspiring traders should consider the opportunity costs of unprofitable trading: for every year that is squandered on unprofitable trading, one misses out on a year’s worth of compound returns from long-term investing.
In this article, we explore the case for a passive strategy for investing in tech stocks over a medium-to-long-term investment horizon. We will present arguments in favour of investing in technology for the long term as well as the potential risks, and why we think tech stocks will continue to outperform the broader equity market at least over the next two decades.
We mentioned that there are opportunity costs to unprofitable trading. Indeed, many successful investors have confessed to having failed miserably at timing short-term market moves at some point during their formative years as an investor. It was only after they acknowledged and accepted their lack of innate talent at predicting short-term market moves, corrected their misconceptions and biases, and adjusted their strategy towards investing over longer time frames, that they finally managed to find persistent success.
These investors got lucky, for most aspiring traders never found their holy grail in trading and never came around to long-term investing. Many ended up spending years of their precious life underperforming a passive investment strategy that could have compounded returns consistently and given them multiple times their money back. Many retirement dreams were shattered in the pursuit of speculative trading.
And this opportunity cost of unprofitable trading is exceptionally high, especially when it comes to technology investing.
As the accompanying chart shows, the Nasdaq 100 Index (NDX) has outperformed the broader S&P 500 Index (SPX) by an extensive margin since 1990. A buy-and-hold investor who invested in the NDX in 1990 would be sitting on a massive gain of 6,627% compared to a gain of 1,144% for the SPX over the same period (not including dividends). This translates into a compounded annual growth rate (CAGR) of around 13.6% for the NDX versus 7.9% for the SPX.
We also included the massive drawdown in NDX during the dot-com bubble (1999-2000) to highlight the risk associated with investing in technology. An unlucky investor who invested in the NDX right at the peak of the dot-com bubble at 5,048.62 points on 10 March 2000 would have suffered a crippling loss of -76.81% when the index reached a low of 1,139.90 points on 4 October 2002. It would take as long as 15 years before the NDX manages to surpass its dot-com peak.
Few investors have the stomach for such volatility and protracted drawdowns. And perhaps this is one of the many reasons why precise market timing seems so irresistible for investors. One only has to avoid the peaks and buy the troughs for technology investing to be an extremely profitable endeavour.
Crucially, what is the real problem here? Is it because technology investing is too risky for the average investor? Or are long investment horizons not acceptable for some middle-aged and elderly investors? Or are investors who are adamant about trying to be the next Wall Street star and who refuse to settle for a boring passive long-term investment strategy the real problem here?
We have already demonstrated the potential for outsized returns by investing in technology. If we take a step further and consider NDX as a separate asset class on its own, it would be among the best-performing asset classes over the last three decades.
Of course, such investment logic would normally attract controversy and be condemned as unorthodox by the investment community. Not only have we completely ignored the lack of diversification by investing in essentially the same category of stocks, but we have also failed to consider risk-adjusted returns. Surely the outsized returns from a technology-heavy portfolio must involve taking on excessive risk, and a less diversified NDX would be much more volatile compared to the broader S&P 500 Index. So are the outsized returns from investing in technology really worth the risk?
Let us now turn to the gold standard measure for risk-adjusted returns. The charts below compare the historical Sharpe Ratios for the NDX and SPX across three different lookback periods (3, 5, and 10 years).
Here we see that risk-adjusted returns on the NDX and SPX follow a similar path over time. There are many occasions when the NDX outperformed the SPX, but there is no conclusive evidence of sustained outperformance on a risk-adjusted basis on a 3-year lookback period.
On a five-year lookback period, we see a more distinct trend of outperformance for the NDX. This outperformance is also persistent and substantial over extended periods of time.
On an even longer-term basis, the verdict is clear. The NDX has persistently outperformed the SPX on a risk-adjusted basis using a 10-year lookback period.
From a risk-adjusted perspective, NDX is a clear winner for patient investors. More importantly, the lack of diversification across sectors didn’t actually result in higher risk without adequately compensating investors with higher returns.
Unfortunately, data for comparing the Sharpe Ratios during the dot-com bubble were not available at the time of writing and were therefore not included in the charts above. But to be fair, we suspect the NDX’s Sharpe Ratio must have underperformed the SPX’s during that period. Nevertheless, the prospect of a temporarily lower Sharpe Ratio during sharp declines in the NDX should not deter long-term investors so long as technology investing outperforms over the long run.
Here at Stratos Capital Partners, we believe that valuation is fundamental to successful investing. However, value is often misunderstood. Investors regularly mistake low prices for value, or high earnings multiples as an indication of overvaluation. We think value is a bit more sophisticated than that.
We argue that the discounted cash flow (DCF) approach of valuing an asset best describes the definition of value. That the value of an asset today is determined by the sum of its projected future cash flows, discounted to the present. In simple terms, the value of an asset today depends on how much returns that asset generates over time. So companies that are expected to grow earnings over time should be worth more than companies with flat earnings.
Therefore it would make sense that high-growth technology companies should trade at a much higher price multiple to current earnings compared to companies in more traditional and mature industries. The NDX’s spectacular performance over the last three decades, therefore, reflects the reality of higher earnings growth among technology companies compared to the broader SPX.
This reality of higher earnings growth among technology companies is demonstrated by the astonishingly short period of time in which current tech giants including Alphabet (GOOGL), Amazon (AMZN), Apple (AAPL), and Meta (META), took to outgrow and overtake the industrial giants of the 1990s.
A passive technology investment strategy is a powerful tool that enhances risk-adjusted returns for long-term investors. Since long-term investing necessarily requires committing to a long investment horizon that stretches over decades, such investors are typically more comfortable with bearing short-term volatility and drawdowns, so long as they are adequately compensated with higher returns.
Of course that is easier said than done. And most investors would be devastated at the sight of a 70% drawdown on the value of their portfolio account. And this explains why very few investors would pursue a portfolio strategy consisting of a 100% allocation to technology stocks. Fund managers who try are more likely to lose their jobs before they could boast of achieving superior risk-adjusted returns for over two decades.
However, one should not dismiss the case for passive technology investing just because one doesn’t have the stomach for large drawdowns. There are various solutions to managing the downside risks of investing in technology. Investors may choose to reduce overall portfolio allocation to equity but increase the concentration of tech stocks within their equity allocation. Or investors may try to be more selective and avoid technology stocks with extremely rich valuations or volatile earnings, thereby leaning towards value and quality.
Every investor wishes to avoid buying right at the peak. And avoiding the peak in investing can be a relatively straightforward and simple task. In fact, there are strategies to ensure that one will never buy at the peak. Dollar-cost averaging (DCA) is one of the easiest strategies to implement and is suitable for investors looking to invest periodically over long investment horizons.
Alternatively, investors may pursue a “buy on a pullback” strategy where rules would only allow adding exposure to technology stocks when prices are in a correction or during a bear market, thereby ensuring they never buy close to a peak. Such a strategy may seem sensible at first, but it usually requires a high level of emotional control and discipline to execute. As 2022 clearly demonstrated, most investors panicked and found themselves overwhelmed by fear to buy any risky assets, let alone tech stocks during the bear market. Few managed to catch the recent rebound and are now hoping for a pullback that may or may not materialize.
There are even a whole bunch of mean reversion strategies and contrarian strategies that are specifically designed to avoid buying at market peaks and selling at the bottom.
Regardless of the various strategies that we have suggested above, the most challenging part of investing will always be psychology. Many investors not only wish to avoid the peaks, but they also wish to buy at the bottom. And it is the fear of buying in a bull market and the greed of wanting to buy at the absolute bottom of a bear market that makes market timing so irresistible.
Building confidence in a strategy is another way to better manage the emotional ups and downs of investing. And perhaps one way to build the confidence to commit to a passive strategy for investing in tech stocks, is to understand the fundamental nature of technology and its indispensable role in a modern economy.
Technology is often mistaken as a particular industry within an economy. However, if we refer to the popular Solow-Swan model, technological progress is presented as one of the major inputs alongside capital and labour when determining the level of output for an economy over time. The main conclusion provided by the Solow-Swan model is that the accumulation of physical capital can only account for economic growth over the medium term and that sustained long-term economic growth is only achievable through technological progress.
The rising role of technological progress in driving sustained long-term economic growth is also demonstrated by how technology-related spending is increasing as a share of disposable income for the average household today. Just a few decades ago, a U.S. household may have spent around 10% of disposable income on a computer desktop that could last several years and software for work productivity and a basic internet connection service. Today, almost every member of the household has access to high-speed internet, a smartphone, a laptop or tablet, streaming entertainment from Netflix (NFLX) or Disney (DIS), paid applications on their smartphone, other electronic gadgets and wearables, and orders food and shop online.
Technology permeating every industry and everyday life is one of the main reasons why technology companies are the ones leading the S&P 500 Index today. And there is no reason to think that technology would slow down in the foreseeable future.
The tech haters will hate, but astute investors should prepare and position themselves for the next wave of technologies to come. The real-world application of artificial intelligence has already arrived and has a long runway ahead while nascent technologies in quantum computing, automation, biotech, cybersecurity, and sustainable solutions, just to name a few, will bring new opportunities in the many decades to come.
One thing for sure is that future tech booms will be unpredictable and potentially volatile. For long-term investors, volatility is a feature and not a bug. Be patient and enjoy the ride.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of SPX, NDX either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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