Many investors seem to think the past 10 years were a waste. Early in 2008 the Wall Street Journal declared the years since 2000 “the lost decade.” That, of course, is one possible interpretation of the market’s behavior since it peaked in 2000, stumbled through a severe bear market for about three years, roared back to recovery and then fell into its current slump late in 2007.

A client referred to the previous 10 years and said to me: “We really didn’t make as much as we expected, did we?” It was more a statement than a question. And it made me curious to know the facts.

What I found didn’t surprise me a great deal. But I think it might surprise many people.

There are probably a million ways to evaluate the investment returns of the past 10 years, which for this article I am defining as the period from January 1999 through December 2008. If you look hard enough, you can pick through those million prisms and probably find evidence to support just about any point of view you choose.

Knowing that, I decided to be especially careful about the questions to which I sought answers.

WHAT INVESTORS “KNEW” ABOUT THE FUTURE AT THE BEGINNING OF 1999

In early 1998, we were in the midst of one of the greatest bull markets of all time, especially for large-cap U.S. growth stocks. Investing was perceived as easy. Risk was widely regarded as an outmoded concept, and it certainly didn’t stop millions of people from loading up on growth funds and technology funds.

Some investors scoffed at us back in 1998 and 1999 when we told them that getting a 10-percent to 12-percent long-term annual return would be very desirable. To them, we were obviously out of touch with reality. Their “reality” included the “knowledge” that the future lay with the Microsofts and the Ciscos of the world, often all wrapped up in the Nasdaq Index.

If you weren’t there, it’s hard in 2009 to imagine how certain this scenario seemed to be. Do you remember the era of newly minted day-traders? Do you remember the people who invested with cash advances on their credit cards “knowing” they could double their money in a year and pay back what they owed?

WHAT INVESTORS “KNOW” ABOUT THE FUTURE AT THE BEGINNING OF 2009

In 2009, to listen to many investors and people in the media, anybody with eyes and ears “knows” that the financial world has fallen apart. People are scared. They don’t want to make commitments, even to portfolios that are demonstrably better than the ones that they already own.

There’s no denying that we have plenty of problems, and I don’t have to remind you of them. Investors are experiencing a lot of raw fear these days, inflamed by the same financial media that only a year and a half ago could hardly contain its enthusiasm about the rosy future described by various investment gurus.

I’m writing about this in order to remind you that the things we are so certain of right now might have little or no value for predicting investment returns over the next 10 years.  

NOW FOR THE FACTS

I want you to look at a two-part table that contains a list of annualized returns from January 1, 1999 through December 31, 2008 and a list of investments that nobody would have believed if I had predicted them at the start of 1999. In the top part of the table are numbers that I know to be accurate. Below is a list of investments, each of which corresponds to one of the numbers above.

Each return in the table assumes an investor made a one-time investment, without adding or withdrawing money. Can you identify which returns correspond to each of the investments described in the lower part of the table?

Table 1: Can you match the annualized 10-year (through 12-2008) returns to the portfolios?

Here are the “answers.”

•    The Nasdaq Index comprised many of the fastest-growing U.S. companies in 1999, including telecommunications and technology. Ten-year return: -3.2 percent.
•    The S&P 500 Index contains a somewhat more conservative mix of large-cap U.S. stocks, including many household names like Proctor & Gamble, Coca-Cola, General Electric and Pfizer. This index is often viewed (inaccurately in my view) as a proxy for the whole U.S. stock market. Ten-year return: -1.5 percent.
•    Microsoft stock was the darling of Wall Street for at least a dozen years. During a period spanning more than a decade, according to a study published in the 1990s by The Seattle Times, there was no period when Microsoft stock failed to at least double in value if it was held for three years. Ten-year return: -4.6 percent. Anybody who had predicted that in 1999 would have been regarded as a lunatic.
•    Bill Miller attained guru status and was often hailed as an investment wizard because he managed the Legg Mason Value Trust mutual fund so that it beat the S&P 500 Index in every calendar year for 14 years straight. Ten-year return: -4.2 percent.
•    For decades, Warren Buffett has been regarded as a legendary investment guru. He still is, even though his Berkshire Hathaway stock (which in many ways resembles a mutual fund with his chosen stock holdings) once lost nearly half its value in a year when almost everything else was gaining. Ten-year return: 3.3 percent.
•    Essentially a definition of stodgy investing for people who don’t want to risk a thing, one-month Treasury bills are regarded as a worthy substitute for cash. Ten-year return: 3.6 percent. In other words, 10 years ago you could have invested in these risk-free securities while the bull market was still raging, and outperformed Microsoft stock, the S&P 500 Index, the Nasdaq and two of the most widely hailed investment gurus of our times.

If you’re reminding yourself that it’s normal to have occasional periods when stocks just don’t do all that well, you are right. If you’re following along, you know that there are two more numbers that we haven’t revealed yet.

•    For many years we have recommended a portfolio of low-cost Vanguard funds that include the equity asset classes we recommend. The results of this and our other public recommendations are tracked by Hulbert Financial Digest, with which we have no ties of any kind. Ten-year return: 3.3 percent.
•    Finally we come to the hundreds of Merriman all-equity managed accounts during this period using a carefully selected group of Dimensional Fund Advisors asset-class funds. Although most of our accounts include fixed-income assets, many clients can tolerate the risk of 100 percent equities. Ten-year return: 4.3 percent. That is the highest return in this table, calculated after deducting our management fees and all other costs.

There you have the facts. I don’t know if anybody actually followed our Vanguard recommendations to the letter for 10 years. But I do know that many of our clients actually achieved our managed all-equity returns of 4.3 percent.

THE ULTIMATE BUY AND HOLD STRATEGY

The majority of our clients have some of their assets invested in fixed-income funds in order to reduce the risks of investing in equities. In an article called “One portfolio for life” a few years ago, we suggested that many people could be well served by a lifetime allocation of 60 percent equities and 40 percent fixed income. This is the allocation we use to construct what we call “The ultimate buy and hold strategy” that we teach in our workshops and describe in an article with that title.

In Table 2, you’ll see the 10-year results of two 60/40 portfolios. One shows results of our managed accounts with this allocation. The other is the result of our Vanguard Balanced Portfolio of equity and fixed-income funds.

Table 2: Two balanced portfolios January 1999 through December 2008

Because of the 40 percent fixed-income allocation, these numbers aren’t directly comparable to any numbers in Table 1. But the time frame is exactly the same. And you can see that each of these portfolios outperformed the all-equity gurus and indexes we cited above.

WHY THIS HAPPENED

I’m not predicting – and I hope you won’t conclude – that our portfolios will outperform the gurus and the averages in every 10-year period. I’m certain that they won’t. But it wasn’t luck that led to this result.

Ten years ago, Bill Miller, Warren Buffett and countless other investors “knew” what kinds of assets would be best for investors. We didn’t, and we admitted it. They said the answer is to invest in certain things that will do better than the rest. We said the answer is to invest in everything (well, a carefully selected version of everything).

Ten years ago we preached the virtues of a portfolio with worldwide diversification invested in low-cost passively managed funds. Ten years ago we explained why we recommended this. If you read “The ultimate buy-and-hold strategy,” you’ll find that our recommendations haven’t changed except for some thoughtful fine-tuning.

We are recommending the same things now that we did in 1999, and for the same reasons. In a nutshell:

•    Follow the asset classes, not the gurus.
•    Keep your costs low.
•    Diversify very widely in asset classes with a long history of good returns.
•    Use a professional advisor to keep you on track during the inevitable times when your strategy gets uncomfortable and may start to seem like a poor idea.

TODAY’S BAD-NEWS INVESTMENT CLIMATE

Today’s news is filled with dire predictions, and many investors feel like owning nothing more risky than cash. We think that’s a mistake, and I’ll tell you why.

I cannot write or speak knowledgeably about the next 10 years, much less the next few decades. But I can remind you of some things that happened in the past 10 years. Remember, these were years when a properly diversified all-equity portfolio was earning a 4.3 percent annual return, after all expenses and fees.

You had no way to know in 1999 that we would suffer two of the worst bear markets (2000-2002 and 2007-2008) in history, that terrorists would commandeer U.S. planes and destroy the World Trade Center and crash into the Pentagon while trying to simultaneously dive-bomb the Capitol.

How confident would you have been in 1998 if I had assured you that the next decade would include panic over Y2K, the suicide attack on the U.S.S. Cole, a presidential election so close that it was finally settled by the U.S. Supreme Court six weeks after the votes were cast, that the United States would invade Afghanistan and later Iraq, touching off a protracted, unpopular war?

Would you have felt confident knowing that Enron, which was then one of the most highly respected large U.S. companies, would collapse in bankruptcy, that Microsoft stock would lose two-thirds of its value in the span of a few months, that a hurricane would destroy much of the city of New Orleans, that India and Pakistan would reach the brink of war, that the price of oil would exceed $140 a barrel and that a big part of our financial system would nearly collapse under the weight of subprime mortgages?  The list could go on and on.

I would like to think that the crises of these last 10 years were unusually severe and that more sublime times lie ahead. But I suspect times will always be trying. Investors often tell me they are waiting for things to “settle down” before they buy or sell investments they know that they should buy or sell. That can be a very long wait.

BAD NEWS IN HISTORY

Imagine that by some magic you could go back to any year at random from the past century and, with the benefit of hindsight, accurately predict the problems, shocks, disasters and challenges of the 10 years just ahead. I bet very few people would be confident as investors if they had that information ahead of time.

Yet despite a seemingly endless string of financial, political and other problems, the U.S. economy has been resilient. Likewise, the stock markets have managed to produce long-term favorable returns. I don’t have any reason to think this is about to end.

Investors who want those long-term returns have to be in the market even when things look gloomy. The early part of 2009 is one of those times. In this article you have seen some real-life returns from the past decade. However, nobody actually achieved those returns without sticking with it. If you pulled out of the market in 2001 or 2002, when things looked truly awful, you almost certainly missed out on at least some of the rousing recovery in 2003, 2004 and beyond.

Above, I cited four things we preached in 1999 and that we preach now:

•    Follow the asset classes, not the gurus.
•    Keep your costs low.
•    Diversify very widely in asset classes with a long history of good returns.
•    Use a professional advisor to keep you on track during the inevitable times when your strategy starts to seem like a poor idea.

I want to emphasize the fourth item on that list. An excellent advisor is one whose financial interests are not in conflict with yours. An excellent advisor will counsel you to follow asset classes, not gurus. An excellent advisor will help you keep your costs low, your tax-efficiency high and your level of risk under control.

If you are not using a professional advisor, I hope you will do so. But choose your advisor very carefully. If you’re thinking of picking a fund, a portfolio or an advisor mainly on the basis of recent past performance, don’t do it.

Here’s one final question for you to think about: If you have an advisor, what was that advisor recommending 10 years ago, and why? How did those recommendations turn out? Is that advisor recommending the same thing now as then?

Now here is a little story that shows you why that matters. A few years ago I was on the investment committee of a non-profit Seattle institution. A sales team from one of the nation’s largest investment managers made a presentation to us bragging about the great asset managers they could offer us. Each of these hand-picked managers had an outstanding track record over the prior 10 years.

When the sales team was through, I asked a simple question: Who were the managers you were recommending 10 years ago, and how did they perform? The sales team didn’t have an answer, and we never heard from that investment manager again.

By contrast, 10 years ago our company advocated wide diversification. We said every investor should have a portfolio fine-tuned to include enough fixed-income investments to restrain the level of risk. For the equity part of the portfolio, we said assets should be divided equally between U.S. and international funds, with an emphasis on value stocks and small-cap stocks.

While this advice seemed old-fashioned and stodgy to many people, some investors followed it. Those who did so are probably glad that they did. And now you know why that is so.
 
 
Paul Merriman is a financial educator and founder of Merriman.