Lesson One: Reality often has little to do with what investors expect

The future is always unknown, and predictions are notoriously unreliable. Anybody who, 10 years ago, had accurately predicted even the biggest events of the decade that we just experienced would not have been taken seriously.

But that didn’t stop people from trying to foretell the future.

Investors polled in 2000 said, on average, that they expected the S&P 500 Index to grow at 20 percent per year in 2000 through 2009. That was seen as a more realistic pace than the 28.6 percent annual growth in the index from 1995 through 1999. Many people thought it was quite unnecessary to diversify much beyond that index.  

The reality: The S&P 500 Index had an annualized loss of 1 percent from 2000 through 2009.

Lesson Two: Hot performance can fizzle out quickly

In the first months of 2000, large-cap stocks, especially those specializing in technology, were all the rage with brokers, commentators and many independent advisors as well. Millions of investors were eager to cash in on the popular success stories that were being created by young high-tech companies. Many people tried to make their fortunes through a new phenomenon known as day trading.

Many brokers and investment advisors regarded Janus, which specialized in technology and other growth stocks, as the No. 1 mutual fund family for long-term investors.

But reality moved in quickly, and boom turned to bust.

Microsoft stock, then a bellwether of technology stocks, lost nearly two-thirds of its value in the year 2000 – and struggled for the rest of the decade without ever regaining even half that lost value.  

As for Janus, the company’s flagship Janus Fund, according to Yahoo.com, lost nearly 55 percent of its value in 2000 through 2002 and had an annualized loss of 4.4 percent from 2000 through 2009.

Lesson Three: Use massive diversification to spread your equity risks

For many years we have recommended what we now describe as massive diversification on the equity side of the portfolio. Our advice was not popular 10 years ago, but we said investors could not know what asset classes would perform the best in any future period. Accordingly, we advocated owning many kinds of assets that had beaten the S&P 500 Index over long periods of time.

In 2000, U.S. large-cap stocks like those in the S&P 500 Index made up only 12.5 percent of the equity part of the portfolios we managed for our buy-and-hold clients. We advocated indirect ownership not of 500 stocks but of 10,000 or more, through mutual funds that invested in U.S. and international stocks, big stocks and small stocks, value stocks, growth stocks and emerging markets stocks.

This turned out to be good advice. The composite of our all-equity buy-and-hold accounts returned 5.4 percent annually for the decade, after fees and expenses, vs.  -1 percent for the S&P.

Today: Our recommendation remains unchanged. Diversify massively, and don’t try to chase recent performance.

Lesson Four: Think small-cap stocks

For more than 15 years we’ve been recommending that investors hold small-cap stocks in addition to large-cap ones. In the decade of 2000 through 2009, this turned out to be good advice. In those 10 years, the Dimensional Fund Advisors Micro-Cap Fund, the small-cap fund we used for client accounts, had a compound annual return of 6.3 percent.

Today: Even though we know that small-cap stocks won’t shine in every year or every decade, we still recommend them.

Lesson Five: Invest in value

For many years we have been recommending value stocks in addition to growth stocks, and this turned out to be worthwhile advice. DFA’s large-cap value fund compounded at 4.4 percent during the decade. The DFA small-cap value fund rose 9.1 percent annually.

Today: The underlying rationale for value stocks hasn’t changed, and we still overweight our portfolios with funds that invest in them.

Lesson Six: The world is full of opportunities

For many years we have recommended international stocks, including large and small, growth and value plus a slice of emerging markets. Our 50 percent weighting in internationals was much higher than most professionals recommended then or now. We said that even if international stocks didn’t return more than their U.S. counterparts, they would most likely reduce the volatility of an equity portfolio.

Based on the returns of DFA funds we use in our clients’ accounts, this turned out to be good advice. International small-cap value stocks compounded at 11.3 percent, compared with “only” 9.1 percent for U.S. small-cap value stocks. Small-cap international stocks rose 8.7 percent, vs. 6.3 for U.S. micro-cap stocks. International large-cap value stocks were up 6.7 percent, vs. 4.4 percent for U.S. large-cap value stocks. DFA’s emerging markets fund was up 9.5 percent annually.

Today: The world is increasingly linked financially, and it’s foolish to think that excellent investing opportunities stop at the U.S. border. We’re still committed to having half our equity holdings in international funds.

Lesson Seven: Most investors need fixed-income funds

A decade ago, we knew that even our unusually broad equity diversification wouldn’t be enough to protect investors from major bear markets. We said investors needed fixed-income funds to get that protection.

Twice in the past decade, all-equity investors paid a high price for being without this protection. In 2000 through 2002, our tax-deferred composite all-equity buy-and-hold accounts lost 18.3 percent (a cumulative loss), vs. a loss of only 6.5 percent for similar accounts with 60 percent equities and 40 percent fixed-income.

In 2008, our composite of all-equity accounts dropped 41.7 percent, vs. only 23.2 percent for those with 60 percent equity.

Today: Many investors in their 20s and early 30s may be able to safely skip fixed-income funds. But anybody who’s in sight of retirement, and certainly anybody who’s already retired, should mitigate the risk of the stock market by owning fixed-income funds.

Lesson Eight: Stick to conservative fixed-income investments

Ten years ago, our clients’ fixed-income exposure was limited to government issues with up to five years’ maturity. This relatively conservative posture provided a lot of protection. Over the past few years we have fine-tuned our fixed-income portfolios. Now we use funds that invest in Treasury Inflation Protected Securities (TIPS) and intermediate-term government funds as well as short-term ones.

Lesson Nine: Moderate-allocation portfolios can be very attractive

About half of our buy-and-hold clients have accounts with portfolios in which either 50 percent or 60 percent is allocated to equities. This moderate approach can provide an appealing combination of growth potential and downside protection.

In the past decade, the composite of our 50 percent equity accounts grew at a rate of 5.6 percent annualized. They suffered a worst-12-month loss (March 2008 through February 2009) of 25 percent, which was greater than we expected 10 years ago. Fortunately, that loss was followed by last year’s strong recovery.

For comparison’s sake, as noted above, the S&P 500 Index lost 1 percent per year and had a worst-12-month loss of 43.3 percent.   

A decade ago, we believed that our 60 percent equity accounts would produce a return similar to that of the S&P 500 Index. Fortunately, we were quite wrong on this point. Our 60 percent equity portfolios compounded at 5.5 percent while the S&P 500 was in the losing column. The worst-12-month loss on 60 percent equity portfolios was 30.5 percent.

Today: We still believe that many investors can meet their long-term  needs with 50 or 60 percent in equities, at substantially less risk than that of the Standard & Poor's 500 Index.

Lesson 10: Bear markets just keep coming back

A decade ago we told investors they should expect serious bear markets, with losses of 20 percent or more, every four to five years. We were right. The past decade included two nasty bear markets.

Actually, we were more right than we wanted to be. In the 20th century, the average loss of bear markets was about 30 percent. The first two bear markets so far this century had average declines of about 50 percent. Ouch!

Frankly, we are tired of bear markets, and we’d just as soon not have two more in the coming decade. But we are unlikely to get our wishes in this regard. We remain committed to helping investors stay the course through whatever storms the market hurls at them.

Lesson 11: Mutual fund families aren’t all equal

Ten years ago we expected that do-it-yourself investors who followed our asset allocation recommendations would do better using Vanguard’s funds than using Fidelity’s. They did.

According to the Hulbert Financial Digest, our recommended all-equity portfolio at Vanguard had a compound return of 4.1 percent in “the lost decade;” the comparable return of our all-equity portfolio at Fidelity was 2.3 percent.

We also believed that DFA funds, which we use in our client accounts, would do better than Vanguard funds even after management fees and trading costs. They did. Compared with the 4.1 percent annual return at Vanguard, our all-equity DFA portfolio (as noted earlier) grew at 5.4 percent.

Today: I believe that DFA’s many advantages will continue to give it the edge over Vanguard, even after our management fee. Fidelity and Vanguard are both good fund families. But I still think it’s valid to expect Vanguard’s lower expenses, greater diversification and lower reliance on active management to beat Fidelity’s offerings.

Lesson 12: Investment strategies continue to evolve

Our recommendations today are very close to what they were 10 years ago, although as noted above, we have fine-tuned our fixed-income recommendations. Our client accounts now include some specialized funds in emerging markets that are not available at Vanguard or Fidelity. And we have added U.S. and international real estate investment trust (REIT) funds to our equity mix.

In addition, our clients have the benefit of some DFA funds that did not exist 10 years ago, funds with fewer transactions, lower costs and higher tax efficiency.

Our recommendations are based on decades of research into what’s most important to long-term investors. They’re the best we can do right now, and I’m certain they will continue to evolve.

What should investors do today?

If you are a Merriman client, you have the benefit of massive diversification in your portfolio. We’ll do our best to steer you away from investment fads. We’ll continue to seek the best ways to make your money work for you. Perhaps most important, we’ll help you figure out how much risk is appropriate for you, and we’ll keep your investments fine-tuned to that risk level.

My charge to you as an investor is essentially unchanged from 10 years ago:

Find solid long-term advice and follow it. Put contributions, withdrawals and rebalancing on automatic pilot if you can. Manage your risk and manage your emotions.

Live within your means (and keep saving money if you’re not yet retired).

And finally, keep the faith. I know this is often challenging, but one of your most important jobs as an investor is to maintain your confidence in the long-term future of our economy and of the economies around the globe.

Once you have all that under control, your job is to live your life fully. That’s what I plan to do in this decade, and I hope you will too.


Paul Merriman is founder of Merriman.

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