Nasdaq’s Mean Reversion is Painful

Chart of the Week for March 2-8, 2001

The Nasdaq Composite’s recent fall to earth provides a great example of mean reversion. This theory states that over the long term, a security or group of securities that has exhibited exceptional over- or under-performance will, at some point, experience a reversal. This change in fortune will be of a magnitude great enough to bring this investment back in line with long-run historical expectations.

The chart above shows that for the five years ending February 2001, three widely followed market indexes have provided almost identical returns. A $1 investment in the S&P 500 Index or the DJIA in February 1996 would have produced $2.09 and $2.08 respectively for the five years ending February 28, 2001 versus $1.96 for the Nasdaq.

The indexes’ performance stresses the need for diversification from the perspective of risk. Even though each of these three indexes had similar returns, the ride for a Nasdaq investor was much rougher. Diversification among equity types should moderate short-term volatility at the portfolio level.

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