Lessons from the "Lost" Decade: Long-Term Investing and Needs Vs. Desires

(MoneyWatch)  A few weeks ago, we looked at some of the investing lessons taught by the markets over the past year. Since we're in a new decade (and many wrongly feel that the past decade has been a lost one when it comes to investing), I wanted to share some of the investing lessons taught over the past decade.
Stocks Are Risky No Matter the Investment Horizon
One of the best-selling investment books of all time has been Jeremy Siegel's Stocks for the Long Run. While the book has much to offer, unfortunately, many investors took the wrong lesson from it -- namely, that stocks are only risky if the horizon is short. Thus, many wondered what went wrong when the S&P 500 Index produced negative returns for the decade from 2000-09.

If you know your investment history, the only surprise would have been the timing of such an occurrence, which, by definition, must be unpredictable. Consider the following:

• For the period 1966-88, U.S. large-cap growth stocks (which returned 7.9 percent per year) underperformed riskless one-month CDs (which returned 8.4 percent per year).
• For the period 1966-82, the S&P 500 produced no real return, underperforming one-month Treasury bills by 0.2 percent per year.
• For the period 1929-42, the S&P 500 lost 1 percent per year in real terms.
• For the period 1990-2008, Japanese large-cap stocks lost 2.7 percent per year.

You must understand that if stocks always beat riskless investments regardless of the investment horizon, there would be no risk and, thus, no equity risk premium. The good news is that because stocks experience both long periods of poor performance and also severe bear markets, the equity risk premium has been large. And while there can't be a guarantee before the fact of an equity risk premium in the future, after the fact there should always be one (with bubbles being the exception).

Don't Convert Desires Into Needs
Converting desires into needs raises the need to take risk. In turn, that results in the requirement for a greater equity allocation to meet the increased financial goal. When bear markets show up, your discipline will be tested. You may have sleepless nights and be unable to enjoy your life. In the worst case, bear markets lead to panicked selling -- something that's difficult to overcome.

One of the most important lessons to learn is that being rich is having the knowledge that you have enough. Keeping needs to a minimum allows you to minimize the amount of risk you need to take in your portfolio. And that helps keep you disciplined.

Another important lesson is to consider how much additional risk you must take to fund any additional spending. Only then can you determine if the incremental psychic benefit gained from the extra spending is worth taking the incremental investment risk.

Follow the series: Lessons from the "Lost" Decade

• Part one: Long-Term Investing and Needs Vs. Desires
• Part two: Rebalancing, Bonds and Correlations
• Part three: Viewing the Past and Future
• Part four: Surviving Bear Markets