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Avoiding Another Lost Decade

Friday, 24 Oct 2008 09:39 AM

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Many investors are panicking. From its peak in March 2000, the major market indexes still show significant losses. Even looking back over the past 10 years provides little comfort. The news media is calling it "the lost decade."

The lament began with a front-page Wall Street Journal article in March of this year that noted the S&P 500 had only gained 1.3 percent over the past 10 years, factoring in inflation and dividends. Since then, the market has continued to lose ground, leaving investors depressed and discouraged about their investments.

Many proactive investors experienced an even larger drop when, in their scramble to beat the markets, they sold what had just gone down to purchase what was just about to go down. Chasing returns often amplifies losses and volatility, so much so that many investors believe they are cursed with the reverse Midas touch: What they bought must go down.

As if to add to the misery, many buy-and-hold investors did not even receive the flat market return. They thought they were purchasing actively traded funds, but they were simply buying closet index funds with overly inflated expense ratios. Excessively loaded fees sapped value from their investments while the underlying strategy went nowhere.

I've said before that we do not recommend S&P 500 index funds. Because the S&P 500 is a capitalization-weighted index, it tends to buy more of a stock when it goes up and hold less of a stock when it becomes more reasonably priced.

If the S&P were a financial advisor it would say, "Let's buy mostly large-cap growth stocks in the industry that did well last year with a high price per earnings ratio."

The result of this advice is a very aggressive and volatile portfolio that does better at the end of a bull market than at the beginning. And it performs very poorly at preserving capital during a bear market, which is exactly what has happened over the last decade.

If you are invested primarily in funds that mimic the S&P 500, a lost decade should be no surprise. If we use market history to run hundreds of Monte Carlo simulations on a portfolio invested in an S&P 500 index fund, projections indicate returns at or below zero about 6 percent to 7 percent of the time.

This scenario is astonishingly accurate of trends in the past 100 years in which six 10-year periods showed no gains. These periods were the 10 years ending in 1914, 1921, 1932, 1938, 1974, and 1977.

If you were invested in the Vanguard 500 Index, your 10-year average return through the end of last month was 3.06 percent. Inflation during the past decade officially averaged 3.0 percent, although actual inflation was probably at least 5 percent.

To make matters worse, your portfolio has dropped again this month. So if you were invested in an S&P 500 fund, your decade-long progress toward your retirement goals is at a standstill.

But if you were smart, you did not lose this past decade. If you were invested in a balanced portfolio, you experienced both higher returns and lower volatility.

Even a balanced portfolio of just six different common funds could have boosted your 10-year average return to 8.18 percent. And it would have lowered your volatility from a standard deviation of 14.4 percent to only 12.3 percent. That is a 5.12 percent better annual return with 2.1 percent less volatility.

The balanced portfolio I used as a comparison doesn't cherry-pick investments that have done the best recently. In fact, this portfolio underperformed the S&P 500 by 7.5 percent over the past quarter. Asset allocation means always having something to complain about.

My comparison portfolio allocates 20 percent to fixed income in the Vanguard Total Bond Index (VBMFX). Of the remainder, it allocates 31 percent to U.S. stocks, with 21 percent in the Vanguard 500 Index (VFINX) and 10 percent in the Vanguard Small Cap Index (NAESX). Another 31 percent goes to foreign stocks, with 21 percent in Vanguard Total International Stock (VGTSX), and 10 percent in the Vanguard Emerging Market Index (VEIEX).

Finally, an 18 percent allocation is made to hard asset stocks in the T. Rowe Price New Era Fund (PRNEX).

The funds just described have been popular for over 10 years. They have not made their gains from active trading, and they have low expense ratios. These are not necessarily the best funds; they are simply typical funds in each of the asset classes.

Theory and practice agree that a balanced portfolio is a far superior way to meet your financial goals. In Monte Carlo simulations, balanced portfolios earn money over a decade, even the bottom 5 percent of random returns. The exact portfolio construction is less critical than including asset categories with a low correlation to the S&P 500.

A well-balanced portfolio should result in good returns with lower volatility. Returns will still vary widely because the markets are inherently volatile, but the worst cases should be considerably better.

Along with my recommendation of a diversified portfolio, the markets continue to provide object lessons and practical labs. Recently, foreign stocks, emerging markets, and hard asset stocks have all corrected more than U.S. stocks and are trading at valuations that make them an attractive way to diversify your portfolio. Holding on to an undiversified portfolio will, on average, keep on providing inferior returns with high volatility. Don't wait for an undiversified portfolio to recover. You can't afford to miss another decade.

________________________________________________________________________

David John Marotta is President of Marotta Wealth Management, Inc. of Charlottesville providing fee-only financial planning and wealth management at www.emarotta.com. Questions to be answered in the column should be sent to questions at emarotta dot com or Marotta Wealth Management, Inc., One Village Green Circle, Suite 100, Charlottesville, VA 22903-4619.

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