Friday, January 8, 2010

Lessons from the ‘Lost Decade’

Bert Whitehead M.B.A., J.D.

The ‘Dow’ and the ‘S&P’ are the most common indexes of U.S. large company stock valuations. At the end of 2009 they closed lower than their opening values at the beginning of 2000. As a result, many economists have dubbed the ‘aughts’ (2000-2009) the ‘Lost Decade.’ They claim that there were no investment gains in the large cap stock market for these past 10 years.

Active money managers will point to the performance of these indexes to crow about the futility of ‘buy and hold’ investing. These managers insist that they are able to add value to an investment portfolio by buying low and selling high, instead of just holding onto stocks. This observation is, of course, tainted with self-interest.

Many ordinary people have sworn off stock market investing because they lost so much money during this period. And with current short term interest rates so close to zero, they are tempted to simply invest in junk bonds or municipal bonds, ignoring that these may be today’s outsized risks.

The truth is that the loss of 8.7% in the Dow during the ‘Lost Decade’ is mostly attributable to the selection of the “starting line.” The beginning of 2000 was near the peak of the ‘dot-com’ bull market. If you start the chart just two months later at the end of Feb. 2000, “voila!” … the market shows a gain! Start the chart two years later in Feb. 2002 and there is a 30+% gain by the end of 2009.

The S&P index outperforms 85% of money managers in the large cap arena over most any 20-year period. The reason? Money managers keep cash in their portfolios, whereas indexes are by definition fully invested. Therefore, managers tend to underperform less in bear markets, and underperform more bullish markets.

If there are any lessons to be learned during the ‘Lost Decade’ it is not about the investing prowess of the active money managers but rather: 1) the advantage of dollar-cost averaging (DCA), especially in down markets; and 2) the necessity of having a diversified portfolio.

DCA is a strategy by which you invest new money on a regular basis, usually monthly, instead of investing all your cash at once. It protects you from investing at the WRONG TIME because you are investing all the time. Most people use their 401Ks or other retirement accounts for their primary investing activity, so they use DCA by default. Investing a fixed sum each month helps you buy more shares of a stock when the price drops. Investing $1,000 per month (plus dividends) over the past ten years would have resulted in a small gain (3.2%) rather than a loss.

Diversifying your holdings beyond large cap stocks protects you from investing in the WRONG TYPE of investment. You shouldn’t invest in any one thing but, rather, in everything. For example, during the past 10 years, small cap and foreign stocks on average appreciated over 30% including reinvestment of dividends. The Vanguard REIT (Real Estate Index) was up over 50%. 20-year Treasury bonds had an average yield of over 5% increasing over 60% during the period.

Dollar Cost Averaging and Diversification are the two primary strategies you can use to avoid investment mistakes. But having said that, the average annual return of a well-balanced portfolio from 2000-2009 (6-7%) fell short of returns for similar prior periods. We usually use assumptions of 7-8% returns for conservatively balanced portfolios over the long term.

Interestingly, the return of a conservatively balanced portfolio achieved the 7-8% long-term return if you start the chart 15 years ago…there’s that starting line issue again.

All of this is small comfort if you bought a home five years ago. Depending on location the value of your home may have dropped over 50%. This is made even worse if your 401Ks have decreased in value despite your contributions over the past ten years. If you lost your job on top of these other setbacks, the last ten years have been ruinous.

No matter what your level of loss, beware the temptation to offset your losses by timing the stock market. It only aggravates your misfortune. Studies repeatedly show that, on average, individual investors who buy and sell stocks in their portfolio underperform the market by a wide margin of 5-7%. They constantly fall prey to trying to select the best time to invest and the best type of investment. It’s far better to avoid this situation by not capitulating to your fears when the market drops, only then having to face buying in a greedy frenzy when the market rises quickly.

The final lesson of the Lost Decade is that it’s merely a story line for writers and editors who need to sell their publications with “new ideas” and “what to buy now!” insights. The Lost Decade is merely the last decade. Select a different time to measure and you come up with different results and story lines.

Unfortunately, the most boring story of all, that consistent investing during good times and bad, is also the most successful for those willing to stick to it. The only problem with it is that it just doesn’t sell this month’s magazine!

I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.

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