Investors ignore the lessons of history at their own peril!
As I was spending an exciting Friday night playing with market analytics software, I noticed some interesting parallels between the late 1990s and the past few years. Starting about 1995, investors started to strongly favor one asset class above all others. If it wasn’t a growth stock, no one would buy it. Most of us remember this as the “internet stock bubble” – but investors poured money into large cap growth stocks as well, fueling an incredible run up in the growth heavy S&P 500 index. The below chart compares the S&P 500 performance (orange) with a well diversified portfolio with 35% US Stock blend, 15% international, 10% Real Estate Investment Trusts, and 40% fixed income.
A $10,000 investment in an S&P 500 index fund in 1995 would have grown to a whopping $35,000 in just 5 years! Meanwhile, the boring diversified portfolio had “only” grown to roughly $2o,000. Investment advisors in business at the time remember this as the time when clients would threaten to fire them if they refused to abandon their principle of diversification to chase ultra hot growth stocks.
What happened next is where we learn a lot about the value of sticking to a sound investment strategy. Here is the same chart, extended to include the next 5 years, 2000 through 2005.
So what we see here is that sticking with the diversified portfolio – even while the neighbors and co-workers were all bragging about “making a killing” in internet stocks, would have paid off quite well. While over the full 10 year time period, both portfolios managed roughly the same return, the S&P 500 investor suffered a whole lot more pain along the way! But most investors in the 1990’s were late to the party. They didn’t experience the bull benefit of the 1995-2000 increase.
Consider two investors who invested a big wad of cash in January of 2000. One chose an S&P 500 index fund which was red hot, the other listened to his somewhat conservative financial advisor and invested in the diversified portfolio of stocks, bonds, and real estate. How did they fare during the following 10 years (which were referred to in the financial media as “the lost decade”)?
The so-called lost decade was not lost for the guy in the diversified portfolio. He doubled his money even while the S&P investor made NOTHING for 10 years! This in spite of the “Great Recession” and financial crisis of 2008!
So what is the lesson for today?
For the last couple of years, markets seem to have moved back to a belief that the S&P 500 and U.S. stocks are the only place one needs to invest. We are four years beyond any talk of “The Lost Decade” and investors have watched the S&P 500 outperforming all other investments once again. In comparison, returns on the staid old diversified portfolio seem kind of boring in comparison. International stocks haven’t done well for a few years. Bonds are doomed the “experts” tell us (and have been saying for 3 or more years now, while they have continued to provide stable returns). U.S. stocks are the only place a sane investor should want to be right?
Am I the only one who sees a similarity here to the first chart from 1990-1995?
Now, I’m not predicting a market crash, I don’t have a crystal ball. Some very smart people say the market is going to keep going up. Other very smart people say it is going to go down. A few doomsayers selling books say that civilization will be coming to an end and we will be foraging for food in a zombie apocalypse. That’s pretty much the way it is every year with the stock market.
With history as my guide, I would never bet against the long term power of diversification. When the market does fall, it is typically the previous market darling that has the farthest to fall – and why not? Popularity drives up prices and valuations. In contrast, small cap and value stocks did not suffer much in the bear market of 2000-2003 largely because they were already (relatively) unpopular before the crash, and so did not have far to fall today. Perhaps the same could be said for today’s laggards (international stocks and emerging markets, perhaps?)
DISCLAIMERS: Investing is risky, and you can lose money. Diversification does not prevent losses, and may not work to reduce risk in every situation. Charts above are estimates with data compiled from returns measured on commercial stock indices. These are hypothetical and not representative of any specific investment product or strategy.