Lessons from the "Lost" Decade: Viewing the Past and Future

(MoneyWatch) 

Sometimes, we can fall into the mistake of not viewing the past or the future correctly when it comes to investing. The past decade has certainly provided some reminders about how each should be viewed.

Never Treat the Unlikely as Impossible or the Likely as Certain
Once again, knowledge of history teaches us that things that have never happened can and do happen. The events of September 11, 2001 provided a powerful reminder. Unlikely events included the unprecedented dramatic fall in the real value of U.S. residential housing and the almost complete shutdown of the corporate and consumer lending markets when Lehman Brothers went bankrupt. (Not to mention that stocks underperformed riskless investments over an entire decade.) The lesson is that you shouldn't take more risk than you have the ability, willingness or need to take.

The Road to Investment Hell Is Paved with Past Performance
Studies on the performance of mutual funds, pension plans and hedge funds show that there's no persistent outperformance beyond the randomly expected. That's why the SEC requires mutual fund advertising include the disclaimer that "past performance does not guarantee future results." It's also why the American Law Institute in its Restatement of Trusts Third, stated: "Fiduciaries and other investors are confronted with potent evidence that the application of expertise, investigation, and diligence in efforts to 'beat the market' ordinarily promises little or no payoff, or even a negative payoff after taking account of research and transaction costs."

The ALI went on to add: "Evidence shows that there is little correlation between fund managers' earlier successes and their ability to produce above-market returns in subsequent periods."

In a triumph of hype and hope over the historical evidence, the majority of investors choose mutual funds based on past performance. The result, according to a recent study by Morningstar, is that while investors buy five-star funds, they end up owning three-star funds! Carrying a three-star fund is like being damned with faint praise because the average actively managed fund underperforms its risk-adjusted benchmark by about 2 percent per year, even before taxes.

The lesson is that you should pay attention to the SEC disclaimer, as well as the evidence from academic research.

The Investment World Is Not Flat
As I mentioned a few weeks ago, the past decade provided evidence that the benefits of international diversification are still present. It's important to keep in mind that while U.S. large-cap stocks may have experienced a negative return over the last 10 years, those who remained diversified should have fared better.

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