Wednesday, June 23, 2010

What Can Be Learned From A Negative Decade For Stocks

Investors might be questioning the traditional approaches to investing after a decade of negative gains in stocks, however, the negative decade is not without precedent. By creating a diversified portfolio covering multiple asset classes and rebalancing their investments on a regular basis, investors will likely experience positive gains over the long-term. See the following post from The Capital Spectator.

Carl Richards, a financial planner who blogs for The New York Times, laments the fact the equity investing has been distinctly unimpressive over the past decade plus. Earning a risk premium in the stock market "is a function of pure luck," writes the founder of Prasada Capital.

It's easy to understand why investors might be frustrated. The S&P 500's annualized total return for the 10 years through the end of May 2010 is slightly negative: -0.82% a year, according to Morningstar Principia software.

Looking at such uninspiring results motivates Richards to write: "This is why so many of us who have been investing for 15 years feel as if we are about back where we started, even if we did everything right (assets allocated, properly diversified, didn’t bail out at the bottom and so on)."

But let's not be hasty in drawing hard and fast conclusions about asset allocation and strategic-minded investing. Let's start by recognizing that the S&P 500 does in fact post a positive annualized return of 6.8% over the past 15 years. A $10,000 investment in the S&P on June 1, 1995 would have grown to nearly 27,000 by the end of last month, based on Principia calculations. Back to where we started? Hardly.

If you've been investing for 15 years and "did everything right" and still don't have much, if anything to show for it, you're obviously doing something wrong. It's not hard to imagine what that might be. If a know-nothing strategy of buying and holding an S&P 500 index fund can generate a tidy gain over 15 years, it takes real effort to throw that away. What are the possible reasons for missing out on the S&P's rise? All the usual suspects come to mind, including going off the deep end in picking individual stocks and excessive trading in and out of the index.

But what about the last 10 years? A slightly negative return for stocks over a healthy stretch of time is a tough fact to swallow. How should we think about that dismal performance? Is there something strange going on in the land of equities? Not really. Annualized 10-year returns for the S&P 500 over various holding periods since the 1930s have ranged from nearly 20% down to roughly flat to slight losses, according to Ibbotson Associates. Granted, most of the time the return is in the 5-15% range, but history reminds that outliers do arrive. Expecting otherwise requires ignoring the historical record.

In any case, most investors should hold a portfolio comprised of multiple asset classes. The full range of investable assets for the average investor includes stocks, bonds, REITs and commodities. The first cut in breaking these broad asset definitions into a finer array of buckets might look something like this:

In fact, passively holding the broad array of asset classes weighted by market value would have delivered a 3.7% annualized total return over the past decade, based on the Global Market Index (GMI), the proprietary benchmark of The Beta Investment Report. Simply rebalancing the mix in the table above back to the passive weights on an annual basis would have boosted GMI's return to 4.6% over the past 10 years. Unusual? No, not at all. A number of studies over the years suggest that a basic rebalancing strategy of multiple asset classes can add 50 to 100 basis points of return vs. the identical portfolio that's otherwise unmanaged. It's not a sure thing, of course, but there's no convincing evidence that suggests you shouldn't expect a rebalancing bonus over the long haul.

The point is that every investor should start thinking about strategy by considering two simple techniques that require no skill or forecasting prowess: 1) diversifying across asset classes using index funds and/or broadly invested actively managed funds; and 2) rebalancing the mix on a regular basis. There are no guarantees that these techniques will always and forever deliver positive returns, much less stellar returns. And in the short term, anything's possible, including steep losses and equally steep gains. But history suggests that asset allocation and rebalancing are a powerful mix when used prudently.

Are there other things you can do to juice return, lessen risk, or tap a bit of both? Yes, but the choices beyond steps one and two entail more risk and some degree of skill is required, and perhaps luck as well. Deciding if you want (or need) to move beyond steps one and two requires careful thought and more than a little research.

By contrast, the first two steps are no-brainers. They're hardly a short cut to easy money, but asset allocation and rebalancing are powerful tools for minimizing the odds of saying you're sorry a decade down the line.

This article has been republished from James Picerno's blog, The Capital Spectator.

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