Lessons from the Lost Decade in Stocks

Before the weather turned cooler recently here in Chicago, I was an avid beach-goer. I love to swim and play in Lake Michigan, pollution warnings or not. But how am I able to wade through a body of water whose average depth is 279 feet? (I'm tall but not that tall.) The answer, of course, is that the lake's depth varies widely, from mere inches at its most shallow to more than 900 feet at its deepest.

The stock market isn't much different. Over very long stretches, stocks, on average, have returned around 10% annually. But in any given year--or even over several years--the stock market can diverge markedly from its long-term average. Throughout the prosperous 1990s, for instance, the S&P 500 Index rose 13% per year. No wonder S&P 500 Index funds were widely touted as can't-miss investments.

The past decade hasn't been so kind, however. Through August 2008, the S&P 500's annualized 10-year gain was just 4.7%. It's been a wild ride along the way, too. After soaring in the late 1990s, the index slumped more than 40% in the March 2000 to October 2002 bear market and then rallied steadily before faltering more recently.

But you've made money over the past decade, right? Yes, but once you account for inflation, which was about 3% a year over that stretch, and any taxes you might've paid, you've done little better than broken even. And you could've made more money investing in bonds. The Lehman Brothers Aggregate Bond Index, the most widely followed bond market index, returned 5.6% over the past 10 years. (True, the after-tax, after-inflation performance in this case wasn't all that great, either.)

In a sense, it's been a lost decade for stock investors. But hidden in the relatively poor returns are some rich lessons for the future. Below are some of the most important.

Lesson One: The long haul may be longer than you think.
We always espouse the importance of thinking long term if you're a stock market investor. But if "long term" means five or even 10 years to you, it might not be long enough. Stocks may have earned around 10% a year, but that's usually when measured over 20- or 30-year increments. Obviously, if you're younger and saving for your retirement, your time horizon is probably long enough to have most of your portfolio in stocks. (Given longer life expectancies, even the not-quite-as-young should have plenty of stock exposure, too.) But if your financial goals are short- or intermediate-term in nature, it's not a sure thing that you'll be better off in stocks than bonds.

Lesson Two: Diversification is your friend.
There's a saying that even in a bear market, there's always a bull market going on somewhere. Put another way, rarely is every stock going down at once (or at least at the same pace.) As the large-cap-dominated S&P 500 was tanking in the early 2000s, for instance, small-value stocks rallied sharply--and kept going even after larger-cap stocks recovered. Over the past decade, the S&P SmallCap 600/Citi Value Index returned 10.2% (and the typical small-value fund gained 11%). Foreign stocks, precious metals, and other commodities, too, have done similarly well. None of those areas were particularly popular in the late 1990s, but investors who stuck with diversified portfolios then ultimately fared better than those who focused entirely on large-cap names. Smaller stocks have historically notched higher returns than large, but they probably won't be as strong over the next 10 years; something else likely will shine instead. But if your portfolio includes stocks of different market caps, styles, and geographic exposures, you don't have to figure out who the winners will be. You'll already own them.

Lesson Three: Dollar-cost averaging is your other friend.
It's true that the dollar you put in the stock market in 1998 hasn't gone all that far over the past decade. But most people usually don't put all the cash they'll ever have to work at once (or at least they shouldn't!). If you're investing through your employer's 401(k) plan, for example, you're probably putting money in the market every time you get a paycheck. In financial-planning parlance, the practice of making regular investments is known as dollar-cost averaging. Doing so helps protect you from overinvesting in boom markets (since stock prices are up, your regular investment amount will buy you fewer shares) and makes sure that you're buying more in downturns (when stock prices fall, your regular investment buys you more shares). If you've been dollar-cost averaging over the past decade, it's true that the money you invested in 1998 or 1999 may not have generated great returns. But if you were disciplined and kept investing throughout the 2000 to 2002 bear market, you bought in at cheaper prices and likely have enjoyed a much better return on those investments.

Lesson Four: Save more.
U.S. consumers have been saving less and less, instead letting the stock market (or their house) do all their heavy lifting. But clearly you can't always count on stocks or your house do the hard work. If your investments aren't growing, there's only one way that you can fill the gap, and that's to sock more money away yourself. Fortunately, you can make your money work harder by using tax-advantaged vehicles like a 401(k) or Roth IRA. Both allow you to compound your savings tax free. In the case of a 401(k), your employer may match the contributions that you make, at least in part. Be sure to put at least enough to capture the full match. Otherwise, you're leaving free money on the table and missing an opportunity to build your savings with no effort on your part.

Lesson Five: Minimize expenses and taxes.
In the go-go late 1990s, many investors didn't care that much about costs. With the stock market rallying 20% or more every year, high expenses didn't matter as much. Take a fund with a 1% annual expense ratio, for example. If the stock market gains 20%, expenses eat up 5% of the stock market's total gain. But in a world of 4% gains--like the past decade--expenses eat up 25%. While you can't control or predict what sort of returns the stock market will give you, you can control what portion of the stock market's returns will be left over after paying expenses.

As one of life's two unfortunate inevitabilities, taxes are tough to avoid altogether. But they eat into your returns just like expenses, so you want to keep them to a minimum. For some tips on how you can reduce Uncle Sam's take, click here.

Lesson Six: The past isn't always prologue.
After enjoying double-digit gains throughout much of the 1990s, investors came to expect fat returns as their birthright. As the last decade has demonstrated, though, you shouldn't necessarily extrapolate the past into the future. But just as it was a mistake to assume that the good times would keep on going in the 1990s, it's equally foolhardy to expect lackluster stock market returns to continue forever. In fact, the stock market has often gone on to post outsized gains after long periods of drought. The long boom of the 1980s and 1990s, for example, followed another lost decade between 1972 and 1982. The moral of the past 10 years isn't that you should give up on stocks. To the contrary, it's probably a better time to invest in stocks than anytime in years.