Traders should be prepared for something unexpected in the markets fairly soon, writes Joe Duarte....
It Wasn't a Lost Decade for Everyone
05/28/2009 3:00 pm EST
We've all heard the mantra that this has been a "lost decade" for equities. From 1999 until the end of 2008 stocks did nothing, or even declined, as they did during Japan's infamous "lost decade" of the 1990s.
But is that really true? And does it reflect how people actually invest?
To find out, I asked The Vanguard Group to study 14 different scenarios in which an individual invested $60,000 in a lump sum or monthly contributions from January 1, 1999 to December 31, 2008. ($60,000 equals $500 a month over ten years.)
We used broad, low-cost Vanguard index funds (and one money market fund) that had been around for the entire decade. We didn't factor in taxes.
In some ways what we found wasn't surprising: If you bought only the Standard & Poor's 500 index on January 1, 1999 and held it until the end of last year, you did badly.
But the broader your stock holdings (small cap, international, etc.) were, the better you did. And besides holding all bonds or all cash, a top performer was a no-brainer 50% stock/50% bond portfolio, with dividends reinvested. Also, lump-sum investing beat dollar-cost averaging handily over this period. (We tested portfolio rebalancing in a limited way and found it added little return.)
My conclusion: Asset allocation is alive and well, and "buy and hold" isn't dead, either—although a growing chorus of people who have a lot to gain from its demise will tell you otherwise. (Next week's column will be devoted to that subject.)
But first, let me walk you through the strategies, starting with the worst. (You can get all the results here.)
Obviously some of the "lost decade" proponents' claims are true: the S&P did terribly during this decade, which spanned the end of the Internet boom, one cyclical bull market, and two nasty bears.
On a pure total-return basis, you would have lost one-quarter of your money by plunking it into the benchmark index and letting it sit.
But by the simple act of reinvesting dividends, you would have reduced your losses by half. And by broadening your holdings to the entire US stock market—including small- and mid-cap stocks—and investing it all at once at the dawn of the "lost decade," you would have cut your losses by half again.
Adding only a small dollop of international exposure ($10,000 out of the $60,000) on January 1, 1999 would have pushed this 100%-equity portfolio close to break even, leaving you with nearly $59,000.
See my point? Even a diversified equity-only portfolio cut losses dramatically.
But when you add bonds to the mix, it gets really interesting.
Obviously bonds were the place to be over the past decade, although not too many gurus pounded the table for them ten years ago. Economist Gary Shilling, a bond bull since 1981, has noted that bonds are the most unloved assets by the people who hold them. When I recommended buying bonds at a conference in Boston in 1999, an attendee complained they were "boring."
Well, how boring is this? If you stuck $60,000 in a broad bond index fund on January 1, 1999, you would have had over $100,000 by the end of last year, an annual return of over 5%. Cash, an even more tedious instrument, would have yielded 3.48% a year, risk-free.
But here's the beauty part: A simple 50/50 split between stocks and bonds would have returned almost as much as our most diversified portfolio of the broad US stock market, developed and emerging market international stocks, bonds, REITs, and cash—over $78,000, or 2.66% annually.
And you didn't need a broker, financial planner, newsletter writer, or financial journalist to put you into it. Heck, a chimpanzee could have recommended it.
During the "lost decade" for stocks, bonds did their job. "We view the bond allocation as there to help temper the volatility of stocks," says Donald G. Bennyhoff, senior investment analyst at Vanguard. Or, as a financial planner once told me, stocks are the engine of a portfolio, while bonds are the air bag.
But what about 2008? Didn't nearly all asset classes—except Treasury bonds, cash, and gold—get decimated?
Of course, they did, and that's to be expected, said David Swensen, Yale University's chief investment officer, in a rare interview on PBS's WealthTrack.
"Diversification isn't going to help in the midst of a financial crisis,…because in these panics…only two things matter—risk and safety," he told host Consuelo Mack. "And people move away from risk, and they move toward the safety of holdings of Treasury securities. And that causes the price of all risky assets to go down simultaneously."
"You have to move beyond the immediate time of the crisis to see the benefits of diversification," he added.
Indeed. As Scott Burns, director of ETF analysis at Morningstar wrote, diversification and asset allocation "reduce risk and maximize return over the long run. Never in the past 75 years did asset allocation remove the risk of investing."
Incidentally, Bennyhoff agrees with me that lump-sum investing has a clear edge over dollar-cost-averaging, as our little study showed. That only confirms some other research on the subject.
"The sooner you put your money at risk, the better," he says.
So, what about the next ten years? Would a 50/50 stock/bond split do as well as it has over the past decade?
Not likely. On January 1, 1999, the ten-year Treasury note yielded 4.65%, according to the Federal Reserve Bank of St. Louis. It hit 2.25% on December 31, 2008. With yields chopped by more than half, is it any wonder bonds rallied?
But according to Vanguard, when yields have been this low historically, that has "led to returns ranging from 1.3% to 2.9% annually over the next ten years."
Or, as Swensen put it, "We could well be at a point where investments in equities are going to produce returns.that are higher than what we've seen in the past five or ten years, and.where bonds are priced to produce lower returns."
History doesn't repeat itself, but the more truly diversified you are, the better off you'll be no matter what the market does. You'll really need to be patient, though. I'll get into that next week.
Howard R. Gold is executive editor of MoneyShow.com. The opinions expressed here are his own.
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