Lessons from the lost decade in stocks

I'm 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 7% annually. (You used to hear investors cite average long-term returns of about 10% for the broad market, but the recent bear market has depressed that figure.) 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 FTSE 100 index rose 15% per year on average.

The past decade hasn't been so kind, however. Through to April 2009, the FTSE 100's annualised 10-year return was negative 3.9%. It's been a wild ride along the way, too. After soaring in the late 1990s, the index slumped almost 50% in the 2000 to 2002 bear market and then rallied steadily before faltering from late 2007 through early March 2009.

You certainly could've made more money investing in bonds. 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 7%-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). For instance, in the US, as the large-cap-dominated S&P 500 index was tanking in the early 2000s, small-value stocks rallied sharply--and kept going even after larger-cap stocks recovered. And while most types of equities, commodities, and some bonds were way down during the recent bear market in both the US and the UK, government bonds came on strong. If your portfolio includes appropriate diversification across stocks and bonds, and within those asset classes you hold securities of varying investment styles, you don't have to figure out who the winners of the next bull market will be. You'll already own them.

Lesson three: Pound-cost averaging is your other friend
It's true that you would have been better off putting money under your mattress than into the FTSE 100 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 pension plan, for example, you're probably putting money in the market every time you get a paycheque. In financial-planning parlance, the practice of making regular investments is known as pound-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 pound-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
British consumers until recently were 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 to 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 put more money away yourself. Fortunately, you can make your money work harder by using tax-advantaged vehicles like a pension schemes or ISAs. Both allow you to compound your savings tax-free. In the case of a pension scheme, 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--if you're lucky--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.

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 lacklustre 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.

This article previously appeared on Morningstar.com on September 16, 2008.