Last Updated Jan 7, 2010 12:26 PM EST
You've probably been seeing stories saying what a horrible decade it's been for investors. Time magazine called it the "Decade from Hell." The Wall Street Journal called it the "Lost Decade." BusinessWeek called it "A Decade of Decay." The Nasdaq was cut in half, they moan. The Dow and the S&P 500 are much lower than when the decade began, they groan.
Don’t believe them. When measured correctly, financial markets weren’t nearly so bad. In fact, if you look at inflation-adjusted returns, this wasn’t even the worst decade of the last four. If you diversified, kept costs low, and rebalanced your portfolio, odds are you actually did just fine.
Index Returns Are Not Market Returns
I don’t dispute that the Dow, S&P 500, and Nasdaq indexes are the accepted standards to measure market performance. Even The Wall Street Journal perpetuates that myth. But none of these yardsticks are actually appropriate measures of the market for three reasons:
First, and most importantly, they measure only the portion of returns that come from stock appreciation. They completely ignore the portion from dividends paid from the underlying stocks. For the S&P 500, this represents more than two percentage points a year. That may not sound like a lot, but compounded dividend gains have amounted to more than half of total returns over the long term.
Second, these indices leave out a lot of stocks. The Dow, of course, is a basket of only 30. The tech-heavy Nasdaq comprises roughly 20 percent of the U.S. stock market. And even the S&P 500 is a stand in for just 80 percent of the U.S. market, ignoring thousands of mid-cap and small-cap stocks. All these indices ignore international markets that, in aggregate, are larger than the U.S. market.
Third, your actual portfolio is almost certainly comprised of fixed-income securities in addition to stocks. Defining the decade’s market performance using just one piece the pie is the wrong way to look at it.
So saying that the Dow, Nasdaq, and S&P 500 are measures of market returns is a bit like comparing apples to small parts of oranges.
How Markets Really Performed
While the past decade wasn’t great for investors — stock returns were far below the long-term 8.3 percent annual return for equities as calculated by Wharton Professor Jeremy Siegel — it wasn’t a complete disaster. When calculated correctly, U.S. stocks almost broke even, as measured by the Vanguard Total Stock Index Fund (VTSMX). International stocks did much better, increasing 2.3 percent annually (26 percent overall), as shown by the Vanguard Total International Stock Index Fund (VGTSX). And bonds had a downright good decade, increasing 6.2 percent annually or 83 percent over the 10-year period, measured by the Vanguard Total Bond Index Fund (VBMFX). These numbers combine the index returns and their underlying stocks’ dividends and net out the costs charged by the funds. In other words, they reflect the returns investors really could have achieved.
If you had added into your portfolio some alternative asset classes, you would have done even better. Vanguard Precious Metals and Mining Fund (VGPMX) clocked in an 18.0 percent annualized return and the Vanguard REIT index fund (VGSIX) turned in a 9.6 percent annualized return, despite the real estate bubble.
Asset Allocation and Rebalancing Paid Off
Investors using the time-honored strategies of asset allocation and annual portfolio rebalancing (to get back to their intended allocation) did best of all. If you held the three total index funds in a moderate portfolio of 60 percent stocks (two-thirds U.S.) and 40 percent bonds, you would have been up 3.13 percent a year, on average, or 36 percent for the decade. Having the fortitude to rebalance annually boosted the return to 3.52 percent annually, for a 41 percent overall return. But the best performance for the decade would have come by combining dollar cost averaging and rebalancing in that diversified portfolio. If you put away the same amount each year and stuck to that 60 percent stock allocation, you racked up a respectable 4.57 percent annual return. Take a bow!
Investment Returns Beat Inflation ...
When you compare investing returns against inflation to get real returns, the ’00s look much better than the 1970s, the worst 10-year stretch over the past four decades. This decade’s 3.1 percent for the moderate portfolio bested the 2.6 percent annual inflation rate by 0.5 percentage points. But the same allocation in the 70’s yielded a negative 0.1 percent real return; that portfolio earned 7.3 percent annually, lagging the 7.4 percent inflation rate.
... But You Probably Still Lost Money
- High expenses: On average we pay 2.0 percent annually to our mutual fund managers, brokers, or money managers so they can, ideally, outsmart other professionals and beat the indices.
- Emotions: We all know that the way to make money in the stock market is to buy low and sell high. But instead, being herd animals, many of us buy when the market is heading up and become panic sellers when the market plunges. Being human costs us another 1.5 percent annually, according to my analysis of the flow of funds from data provided by Morningstar.
Even though positive returns were there for the taking this decade, very few investors actually got them. That’s because of two investor enemies:
As a result, after you take expenses and emotions into account, the average investor was lucky to break even this decade.
Advice for the Next Decade
So how can you increase your chances of making money in the decade ahead?
First, set an asset allocation for your portfolio and dollar-cost-average your investment dollars into low-cost, broad index funds. Then, rebalance the portfolio when your asset tilt gets out of whack because the markets surprise you, as they surely will. This means forcing yourself to buy stocks when they’re down and selling when they’re up. Doing so allows you to take advantage of irrational investor behavior rather than being a victim of it. Finally, reframe your expectations. Instead of comparing your returns to the indexes, check your performance against total market returns.
Don’t buy into the hype that asset allocation is dead and that now is the time for active investing. Arithmetic works every bit as well in bad financial markets as it does in good markets. If you see ugly returns on the indexes in the next decade, just smile and realize how much better you are actually doing.
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