The 10-year period from 2000-2009 has been referred to as the "Lost Decade."
During these years, the 10-year average annualized return of the U.S. equity market (as measured by the S&P 500) was -1 percent (-0.95 percent to be exact).
A $10,000 investment on Jan. 1, 2000, was worth $9,089 on Dec. 31, 2009.
To put this performance into perspective, there have been 75 consecutive 10-year periods (rolling decades) since 1926, and the average 10-year average annualized return for the S&P 500 over those 75 periods was 10.8 percent.
Still, the Lost Decade was only lost if you were 100 percent invested in large-cap U.S. stocks. In fact, the last 10-year period was one of only four such periods since 1926 in which the S&P 500 produced a negative average annual return. The other three periods were 1929-1938 (-0.9 percent); 1930-1939 (-0.1 percent); and 1999-2008 (-1.4 percent).
On the other hand, if you were hunkered down in an all-bond portfolio between 2000 and 2009, you had a better-than-average experience. Likewise, if you had a marginally diversified portfolio (such as a blend of 60 percent large U.S. stocks and 40 percent bonds), you emerged at the end of 2009 with a modest gain. In retrospect, the Lost Decade was actually a referendum on the importance of asset allocation and diversification.
NOT EITHER/OR
Investors could have invested in a 100 percent bond portfolio during the Lost Decade. If they had, they wouldn't feel lost. In fact, the 10-year annualized return for a portfolio consisting entirely of U.S. bonds (using the Barclay's Capital Aggregate Bond Index) was 6.3 percent between 2000 and 2009. The average 10-year rolling return over the 75 10-year rolling periods since 1926 was 5.6 percent.
In fact, the average U.S. bond return of the first 39 10-year rolling periods was 3 percent. There were 11 consecutive 10-year periods where the annualized return was below 2 percent during the 1940s and 1950s.
More recently, the performance of U.S. bonds has dramatically improved. The average return of the most recent 36 10-year rolling periods has been 8.4 percent.
A 60/40 portfolio, as you would expect, generates returns between the return of an all-stock portfolio and an all-bond portfolio. The average 10-year annualized return for a 60/40 portfolio over all 75 10-year periods was 9.1 percent. During the 10 years from 2000 to 2009, a 60/40 portfolio had an annualized return of 2.6 percent - not up to par historically, but not necessarily a Lost Decade. The 60/40 portfolio was rebalanced annually.
WINNERS AND LOSERS
In general, stock mutual funds were not entirely lost during the past decade. There were 1,825 U.S. equity funds that survived the entire 10-year period from 2000 to 2009. The average 10-year return of these funds was 2.2 percent, and 68.5 percent of the 1,825 funds had a positive 10-year annualized return.
Admittedly, these are the survivors. We can assume that the majority of funds that failed to survive the entire 10-year period would have had a return well below the average.
DIVERSIFICATION DESIRE
In as much as most investors can and should diversify, the most relevant question is how a well-diversified portfolio performed during the Lost Decade. A multi-asset model known as the 7Twelve portfolio will represent a broadly diversified portfolio.
Throughout the Lost Decade, a multi-asset portfolio consisting of exchange-traded funds, rebalanced back to equal 1/12 allocations annually, produced a 10-year annualized return of 7.8 percent. (If the portfolio was rebalanced monthly, the 10-year annualized return fell slightly to 7.5 percent.)
References to a Lost Decade are really references to poor asset allocation. The S&P 500 is a one-asset index - it contains only large U.S. companies. As a result, during a tough decade for equities, it failed to produce a positive return.
Funds that mimic the S&P 500 are perfectly suitable portfolio ingredients, yet they do not represent a diversified portfolio by themselves. Five hundred similar holdings do not create broad diversification. They may create holdings depth, but portfolios need asset breadth to be diversified.
Portfolios need more than one asset class to achieve genuine diversification. Even a simple two-asset 60/40 portfolio generated a positive return of 2.6 percent during one of the most dismal equity markets since the late 1930s.
A more broadly diversified and annually rebalanced 12-asset portfolio generated a 10-year annualized return of 7.8 percent, which was three times higher than a simple 60/40 portfolio returned. In short, the simple antidote for any Lost Decade is genuine diversification.
AT THE CORE
Simply put, every portfolio should have a diversified core component. This multi-asset core will be the same for every client, so financial advisors should not be wasting their time designing different core portfolios.
Rather than designing every portfolio from the ground up, advisors should determine how much of the multi-asset diversified core component to use and what type of "explore" assets to add to the core to best meet each client's unique needs. Essentially, a portfolio's core should become a commoditized product that all advisors use uniformly.
Advisors add their considerable value by knowing which individualized "explore" assets will help clients realize their goals over their investing lifecycle. With this structure in place, the likelihood of losing a decade or two along the way is very small.
Craig L. Israelsen, Ph.D, is an associate professor at Brigham Young University, designer of the 7Twelve Portfolio (www.7twelveportfolio.com) and author of 7Twelve: A Diversified Investment Portfolio with a Plan. This article originally appeared in Financial Planning magazine.
