It’s no secret that the 2000s was a bad decade for the major U.S. stock market indices. The S&P 500 lost an average of 1% per year, some 3.6 percentage points worse than inflation, making it the worst decade for real returns on record.
But in a recent paper, Research Affiliates’ Rob Arnott notes that the broader market’s struggles didn’t mean that the 2000s were a lost decade for investors. According to Arnott, investors who truly used proper diversification and bought stocks using fundamental-weighted index funds actually could’ve posted returns close to 9% per annum.
Arnott says a big mistake that investors make is being wedded to a 60%/40% stocks/bonds portfolio. “Risk premiums are time varying and greatly depend on starting valuations,” he writes in a piece published by IndexUniverse.com. “Stocks — like any other asset class — will disappoint us if we buy them when they’re expensive and will delight us if we buy them when they’re cheap. … If we build our portfolios to hold more of an asset when it is expensive and less when it is cheap, we’re likely to see a return drag.”
And, entering the 2000s, many parts of the stock market were very overpriced and primed for poor returns, Arnott says. But other areas — and other assets — were not, and many fared quite well. For example, emerging market bonds, Real Estate Investment Trusts, and emerging markets stocks all produced annual returns of 10% or better for the decade, Arnott says.
Other asset classes, like emerging nation local currencies, Treasury Inflation-Protected Securities, Long-Term Treasuries, Long-term credit, and commodities all were in the 7% to 8% range. And, if you’d equally weighted a group of 16 different asset classes, it would have resulted in a 6.8% annualized return during the 2000s, Arnott says.
In addition, Arnott says that those who used fundamental indexing — which weights holdings by economic fundamentals, not market cap — for the equity portion of their portfolios would have added even further to returns. One example: They would have avoided much of the tech meltdown in 2000 (when tech stocks’ market values far exceeded their underlying values). “Simply, the Fundamental Index methodology eliminates price from the portfolio weighting process and is, thus, immune to the corrosive effect of being overweight the overpriced (tech in 2000) and underweight the underpriced (financials and industrials in 2009),” Arnott contends. Those who used the same 16-asset-class diversification throughout the decade but used fundamental indexing rather than cap-weighted indexing to purchase stocks would’ve earned 8.5% per year, he says.