The first score of the century is in the history books. It was the best and worst of times, but in the reverse order. The lost decade was followed by the longest bull market in history. Overall, it was not so good for U.S. stocks, downright bad for international stocks and outstanding for high-quality bonds.
Let’s walk through the first 20 years of the new millennium and the lessons for the next 20 years.
Those 20 years came in as follows, based on total returns including dividend reinvestments:
These results use the broadest index funds, after fees. I used the more expensive investor class Vanguard funds as 20 years of history is available only for these funds. Actual returns would have been a tad better using lower-fee Admiral funds or ETF share classes when they became available.
From the dawning of the new age economy to the bursting of the dot-com bubble
The century began with the widely held belief that we were in a new era where cash-flow no longer mattered. Internet companies with little revenue and huge losses had valuations in the tens of billions of dollars. Critics of those valuations were scolded for their old-school thinking and failure to understand that things were different in the new economy. U.S. stocks peaked on March 24, 2000, and quickly plunged by nearly 50%. Many thought this would be the most painful period of the century, but it was only the first plunge of that decade.
Clients came to me bewildered. How could they have lost over 70% of their stock portfolio when they owned several mutual funds they thought were diversified? The answer was obvious; example were the several Janus mutual funds that all owned the same dot com companies. A total-stock index fund was far more diversified. High-quality bonds, REITs and precious metals and mining stocks had low to negative correlations and did well during this bear market. The plunge ended in in October 2002, and though U.S. and international stocks had each lost about 49% of their value, high-quality bonds helped ease the pain, gaining 28%.
The real estate and financial bubble
The pain of the dot com bubble was soon forgotten as stocks soared to new heights. This time, the bull wasn’t based on billion-dollar IPOs with little revenue – it was real, as in real estate. You can’t print more real estate, right? If people default on mortgages, they are secured by real assets and real estate goes up in value. Between October 2002 and March 2007, U.S. stocks gained 133% and international stocks gained 240%. Bonds lagged, gaining only 22%.
Back then, I told clients a third of their equities should be in international stocks and the typical response was “why only a third – isn’t all the growth coming from overseas? We want whatever is hot.”
This bubble burst and was many times more painful than the earlier plunge. The magnitude of the decline was only slightly more than the dot com bubble, with U.S. stocks losing 55% and international dropping 60%. What made it so much more painful was that it burst twice as fast as the last bubble, making it far more vivid. In a stroke of bad luck, I happened to be in New York near Wall Street on the bloodiest week in October 2008, where the fear was contagious.
Total bond funds hung in, gaining over 7%, but Morningstar reported that the average bond fund in 2008 lost 8%. In fact, many bond funds lost more than stocks. And those REITs and precious metals and mining stocks that worked so well when the dot com bubble burst failed miserably during this plunge. Every plunge has its own cause and effect.
A critical role of financial advisors is to keep their clients disciplined with a relatively stable asset allocation between risky assets (stocks) and low-risk assets (bonds and cash). But advisors timed the market poorly. T.D. Ameritrade Institutional accidentally disclosed allocations on its advisor platform. The average allocation to risky assets was 74% at the height of the market on October 9, 2007 and only 49% at the bottom on March 9, 2009. “My client made me get more conservative” was an excuse I often heard from advisors.
Some clients asked if I could promise the bottom was near and, of course, I had to say I couldn’t. All I could say is capitalism will survive and selling now guarantees you’ll never reach your financial goals. I told clients that if markets don’t recover, I’m going down with you. Research demonstrates that losing money hurts a bit less if others you know are losing it as well. Buying stocks in late 2008 and early 2009 was agonizing.
Though stocks recovered very quickly after the March 9, 2009 bottom, it was a lost decade, with U.S. stocks losing 2% and international gaining 28%. High-quality bonds were the star, gaining 81% with lower rates. Top economists chimed in that rates had to go up, though those were the same economists whose track record on forecasting the direction of interest rates was around 30% – worse than a coin flip.
The longest bull in history
On March 9, 2009, the longest bull market in history began. From then to the end of the next decade, returns were good for international stocks and bonds and fantastic for U.S. stocks.
With international stocks lagging, I still recommend to clients that a third of their stock portfolio should be international. But many clients say, “I can’t go that high – there are too many problems overseas.”
Mistakes I saw over the last decade were:
• Waiting for a pull back to get in (aka market timing);
• Using alternatives such as managed futures, market neutral, or inverse index funds; and
• Thinking there were safe alternatives to bond funds such as master limited partnerships.
Seven lessons learned
What have we learned as advisors and investors? Here’s my take:
1. Advisors have emotions. We must keep our own emotions in check in order to help our clients to do the same. It’s better to keep the client disciplined even if we get fired for doing so.
2. No one knows the future. This is true whether we are talking stocks or bonds. Our job is to steer the client away from crystal-ball expectations and toward disciplined allocations that match what we think are the clients’ willingness and need to take risk.
3. Embrace and remember the pain. For me, nothing evokes the emotions of that time more than this CBS MoneyWatch video filmed two trading days before the market bottomed in March 2009. Though I can remember saying all the right things, my inner voice was saying – “please, please, please let me be right!” Reliving those painful memories make me a better investor and advisor.
4. Don’t talk to clients in concepts but rather in consequences of the next bear market. Help them visualize what their lives would be like in a Japan-like scenario where stocks haven’t recovered from the 1989 highs. Help them imagine their new lives on what they would have to give up with those losses.
5. Bonds should be boring. High-quality bonds tend to zig when the market zags. Even investment-grade corporate bonds tend to decline when stocks plunge. A key role of fixed income is to keep up with inflation and taxes.
6. Every bull and every bear is different. Don’t count on what worked in the past to work in the future.
7. Bubbles are easy to spot in hindsight but not so much at the time. Are we in one now? I know I don’t know.
The next two decades will be just as emotional as the last two. Reflect on what you what you learned from the last two decades and buckle up. There will be turbulence, so hold on tight.
Allan Roth is the founder of Wealth Logic, LLC, a Colorado-based fee-only registered investment advisor. He has been working in the investment world with 25 years of corporate finance. Allan has served as corporate finance officer of two multi-billion dollar companies, and consulted with many others while at McKinsey & Company.
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