The worst dotcom bubble risks are coming for your money. Avoid them

Many investors remain enamored with the so-called “Mag 7” and the tech-led U.S. stock market. A history lesson may be in order so they don’t get hobbled by mistakes that sank portfolios in the early 2000s.

While there are differences in today’s market, the phase we are in resembles the period before the dotcom bubble burst in some important respects. During the dot-com heyday, many market participants became overly concentrated in the technology sector and ultimately lost big.

“People get caught up in the hype,” said Seth Hickle, chief investment officer at Mindset Wealth Management in Indianapolis, Indiana. Many investors bought into the tech sector after enormous gains had already happened, ignoring valuations and overestimating their risk tolerance until volatility showed up in their portfolio, Hickle said. 

The warnings are being voiced every day. JPMorgan CEO Jamie Dimon told CNBC Contributor Wilfred Frost on Monday that he wouldn’t buy stocks at these valuations. (Dimon said he wouldn’t buy long-dated treasuries either.) Warren Buffett recently told CNBC’s Becky Quick that “It’s tough to find values when everybody is preferring gambling.” 

Financial advisors say the first step is to have a strategy — and recognize that chasing gains isn’t one. Many investors during the dotcom years were content with the latter. A strategy for investing has to be set before you invest, and it has to include a plan for cashing out some of your chips. To mitigate bad decisions based on emotions, you’ve got to know what you’re buying, why, and when it makes sense to get out, said Dan Sudit, partner at Crewe Advisors in Salt Lake City. 

Financial advisors caution that there is a tendency among investors to repeat the mistakes of the past. Technology is core to the stock market and its role in future long-term growth will continue, but there are ways to gain exposure to technology high fliers without repeating the mistakes of the dotcom era.

S&P 500 funds are meaningful tech bets

One of the problems during the dotcom era was that investor portfolios became too tech-heavy. The same could happen today if people aren’t careful. AI is quickly reshaping society, and many investors want to buy stocks or funds to benefit from its expected growth. However, many investors already hold top-performing stocks within their core portfolio — and some don’t even realize it. Aaron Ulrich, owner of Integra Financial Planning, in Prospect, Kentucky, says clients often ask him about well-performing stocks like Nvidia, Tesla and Apple without knowing they are part of their diversified portfolio. 

Instead of trying to pick the next big winner, or investing in a single sector ETF, investors should diversify. For many investors, owning a core ETF that tracks the S&P 500 Index is a good starting point because it has “meaningful technology exposure” and also provides diversification, said Shannon Saccocia, chief investment officer of wealth at Neuberger Berman in New York. Outside of U.S. large-cap stocks, investors should invest a portion of their portfolio in small-cap stocks, international companies, emerging markets and energy companies, Saccocia said. 

A diversified strategy is better than trying to pick the next wonder, Ulrich said. “We don’t know the next Nvidia. The idea that we can, today, know the one stock that’s going to be up 2x, 5x or 10x over the next two to five years is impossible. Those same stocks can go down considerably,” Ulrich said.

Don’t buy what you can’t afford

While the prospect of making gobs of money by investing in a particular sector can be exciting, Ulrich talks with clients about their time frame and risk appetite, helping them understand how much above their daily needs they can afford to invest. Their long-term goals also factor into these decisions. 

When the dotcom bubble burst, many people lost substantial savings they couldn’t afford to lose. At that time, Sudit lived near a retired couple who lost a significant portion of their savings by investing in dotcom stocks. The husband put about half of the couple’s investable assets in the technology sector, and when the losses started piling up, they had to downsize their home and tighten their budget, meaning they couldn’t afford vacations they’d dreamed of, new cars, or to help grandchildren with education. People have to be careful not to let excitement about a particular sector get in the way of reason, Sudit said. “You may have to let opportunities pass because you can’t afford the massive risk.”

Limit thematic, sector investing to 20% of equity portfolio

Some investors are drawn to investment themes. If that’s the case, they can look at investing thematically, but only after they build a core equity portfolio. Around 80% of an investor’s equity exposure — a figure that depends on age, time horizon, risk tolerance and other factors — should be well diversified, Hickle said.

To get broad-based exposure, the core portion of the portfolio might include ETFs that follow the S&P 500 and the small-cap stock-focused Russell 2000. The Nasdaq 100 is also a popular core holding — it excludes financials and is technology-focused (close to 70% of the fund’s portfolio is tech sector, as of June 30). But it also has considerable stock overlap with the S&P 500, so be aware for diversification purposes.

Then, with the remaining 20% of the equity exposure, an investor can choose investments that help express the themes they are most interested in. Some clients do this by picking individual stocks. Another option is to look at ETFs that focus on specific themes or sectors, such as the State Street Select Sector SPDRs, which break down the S&P 500 by industries including financials, healthcare and energy. When buying thematic ETFs, which now include many funds targeting AI and other tech innovations (space stocks are a recent example), investors should try to ensure there’s not too much overlap with their core portfolio, Hickle said.

“I would never just own one sector ETF because you could be wrong,” said Neale Ellis, founding partner and co-chief investment officer at Fidelis Capital in Dallas. 

Someone who wants additional exposure to high fliers might also consider options that offer some upside, but also limit their downside exposure. They could consider, for instance, hedged ETFs such as the JPMorgan Hedged Equity Laddered Overlay ETF (HELO), T. Rowe Price Hedged Equity ETF (THEQ) and Parametric Hedged Equity ETF (PHEQ). 

Consider the tax effect

Investors who want exposure to high fliers often forget they are growth investments, not income-producing, so they’ll produce meaningful capital gains, according to Sudit. Short-term capital gains are taxed according to ordinary income tax brackets. After owning the investment for a year, you’ll be taxed at long-term capital gains rates. 

It’s important to consider taxes because selling a popular technology stock or fund could result in a large tax hit, though it still might be a prudent move if you’re in over your head in risk. 

Sudit had a client who, during the dotcom period, invested $5,000 in a high-flier dot-com stock, without consulting an advisor. He hoped the growth would give him funds to buy a sports car within the next year. He got his 10x return, but the stock appreciated so much that selling would have meant huge capital gains. He didn’t take chips off the table, and the company went belly-up. In this case, the client could afford to lose his initial investment and the paper gains, but that’s not true for everyone, so investors have to be mindful.

There may be options for tax-loss harvesting. This involves selling securities at a loss to offset capital gains or lower taxable income, resulting in a reduced tax liability. Even if you have a tax bite, it could still be worth selling an investment that’s overly risky, Ulrich said. “You don’t want to hold onto something that you know is not working. Whether it’s up or down, if you have concerns about your level of risk inside your portfolio, it doesn’t make sense to keep holding that so you effectively take on more risk.”