What can the echoes of the dot.com bubble teach us?

Worrying about a correction is easy. Far harder is knowing how to navigate it. Everyone knows the stock market will fall at some point. But identifying when and how far is hard. We are told that the past is no guide to the future, but really it is all we have to go on. So, what can the history of stock market booms and busts tell us?

This week, I looked into what happened during one obviously relevant period for investors today - the four years from 1998 to 2001. There are many echoes of that dot.com bubble today. The first two years saw a surge in markets on the back of a compelling technology theme that drove a narrow set of shares to very high valuations. That sounds familiar. Whether we also repeat the second half of the period, when the bubble burst, is the key question for investors today.

It's tempting to think that markets simply rose in 1998 and 1999 and fell in 2000 and 2001. At the headline level that is true. But beneath the surface there was a lot more going on. Some shares did poorly in the boom years and outperformed when the tide turned. To some extent, that divergence was able to protect investors. Might it help us navigate a correction today?

To measure the impact of the boom and bust on a typical investor with a balanced portfolio, I tracked six well-known UK shares from two years before the market’s peak on New Year’s Eve 1999 to two years after. My choice of shares was unscientific but not random. It included three tech shares: Vodafone, BT and Sage. I balanced these with three defensive stocks: Unilever, Imperial Brands and Severn Trent.

The journey the six shares took during those four years will not surprise anyone old enough to remember that time. The technology shares performed extremely well for the first two years and then did very poorly in the second two. The defensive shares did badly for the first half of the period and then recovered.

An investor holding these six shares at the start of 1998 knew nothing of what the next four years would bring. They had a range of options, however, relating to the balance between the two types of share and the timing of their moves in and out of each.

The benefit of hindsight is that we can now see how those various choices panned out. I tested ten scenarios. Here’s how they rank in terms of the returns they each delivered through the end of 2001.

The most successful approach was the least plausible. It was to invest solely in the tech funds for the first two years to the peak and then switch wholesale to the defensive stocks. Let’s assume a starting capital of $600, split evenly. It grew to over $4,800 during the four years for a 711 per cent return, including re-invested dividends. Capital was built in the boom and then held onto. It’s nice to think we could time the market this well. But perhaps unrealistic.

The least successful approach was, thankfully, also implausible. Investing just in the defensives throughout the two-year boom, and then shifting into the tech stocks right at the peak, turned the same $600 into $235. Painful, but unlikely.

The more interesting scenarios are the ones that come closer to how people actually behave.

One approach would have been to simply hold all six shares throughout the four years. This hands-off approach turned the same $600 into $1,060, a 77 per cent return. Two other do-nothing strategies delivered surprisingly similar returns. A Luddite gambit - holding the defensives throughout - delivered $986, a 64 pr cent return. Meanwhile, a Tech Bro portfolio - investing only in the internet-related stocks - left you with $1,134, an 89pc return.

Attempts to finesse the bubble through timing and stock picking were a mixed bag. Panicking early was a reasonable strategy. Holding all six shares for one year, then going defensive for the next three as the bubble inflated, would have left you with $1,147, almost the same as going all in on the tech theme. It was a better approach than holding all six for a year and then jumping on the tech train. Reduced exposure to the first year of tech returns capped this pot at $976, a 63 per cent return. Better this, though, than switching the diversified portfolio into tech shares a year later at the peak. This turned the starting $600 into just $722, a 20 per cent return.

Perhaps most interesting, because plausible, is an approach I would call bandwagon jumping. This flexible approach held all six shares for the first year, shifted into tech for a year either side of the peak, and then reverted (after an exhilarating then bruising journey) to a balanced portfolio again for the final year. This strategy doubled your money, turning $600 into $1,221. It was a significantly better approach than the opposite gambit, going defensive either side of the peak. This approach, which feels like what many of us would really want to do today, turned $600 into $914. Not a disaster, but a missed opportunity.

Two dangers emerge from this analysis. Getting sucked in late is one. But almost as risky is missing out through a surfeit of caution while the party is still getting going. In the absence of a crystal ball, there’s merit in simply holding a balanced portfolio and riding out the ups and downs along the way.

By the way, if you had held all six shares from the start of 1998 until now, reinvesting your dividends, you would have turned $600 into $9,745, three times the return of a passive FTSE 100 investment. And the best performer, by a country mile? Resolutely old economy Imperial Brands. Who would have predicted that in 1998?

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Please note that the views expressed in this article are my own.