Say say two thousand zero zero party over, oops, out of time
So tonight I'm gonna party like it's nineteen ninety-nine
When Prince originally wrote the song 1999, thoughts of the "dot.com bubble" and two bear market selloffs in the following decade were probably furthest from his mind. Many have forgotten or never experienced the “lost decade.” Unfortunately, those who have forgotten are most likely to repeat the mistakes of the past. Taking a look at the common mistakes of this decade and what could have been done to protect from these missteps, we see many similarities to today.
Many financial planners were not practicing in the late 1990s and are not likely to recognize the similarities between then and now. Index funds became more and more popular as it looked foolish to diversify when the S&P 500 fared much better than anything else save technology stocks and the latest dot.com IPO. So what lessons bear repeating from twenty years ago?
Lesson #1 – Avoid Indiscriminately Buying the Biggest Most Popular Companies.
Last year we decided to take a look at the largest most popular companies of 1999 and see how some of these companies have fared over the past two decades. Just looking at the ten largest market-cap companies from 1999 and how they have fared through the beginning of this year, we can see that only two have grown in value. The company formerly headed by Bill Gates has done best and has grown by just under 2% per year while the company formerly run by Jack Welch has done worst and has lost over 8% in market value per year since 1999. We find that twenty years later, many investors feel they are “safe” buying and holding the largest most popular companies and may suffer from the same mistakes many made twenty years ago. Many of the best performers of the last twenty years were much smaller, lesser known companies at the time. Others were left for dead only to rise from the ashes and give investors significant upside. Warren Buffett is fond of saying “You pay a very high price in the market for a cheery consensus” and has proven that buying companies when they are relatively unknown or unpopular is more profitable over time.
Click the picture above to see how the world's most valuable companies have changed over time.
Lesson #2 – Stay Diversified
The most extreme example of “failure to diversify” would be to own just one company stock. In the opinion of most informed investors, this is not a wise or viable strategy. Instead, we will define a “Non-Diversified” portfolio as one that represents just one asset class, U.S. large-cap stocks represented by the S&P 500.
This “Non-Diversified” portfolio over the “worst 30 year plus” period of the last century still gave us a return slightly over 8%, but all investors in stocks know that this ride was not without bumps along the road. Since the early 1970s the S&P 500 has finished the year down roughly a quarter of the time, 2008 being the worst, down -38.2%.
A highlight of the worst year, 2008, does not measure the full magnitude of losses incurred by this portfolio. The accompanying graph illustrates one of the worst total losses sustained by this “Non-Diversified” portfolio, a 46.3% loss during the 2000-2002 bear market. This is an illustration of a “Drawdown”. The accompanying graph further illustrates the 85 months to return to the previous high, an example of measuring “Peak-to-Peak” recovery times.
Conversely, a “Simply Diversified” portfolio adding small company stocks, international stocks and bonds reduces volatility by close to a third and reduces the maximum drawdown over this same period by over 24%. Furthermore, the time it takes to recover losses is reduced to 52 months.
As can be seen from the chart below, bonds suffered least and small companies fared best over this time period immediately following the 1990s bull market.
Small companies and particularly, small value companies outperformed significantly during the decade following the technology bubble. The same “worst 30 year plus” period that gave us an 8% return for the S&P 500 gave us a 12.8% return for small company value. Lately, small company value has not fared so well, lagging the S&P 500 by over 7% a year for the last five years. The last time we saw small companies fare so poorly versus the S&P 500 was the end of the 1990s. Those who sold these underperformers going into the year 2000 missed out on the 20%+ outperformance over the S&P 500 over the next five years.
By diversifying further into emerging markets, real estate and other alternatives, maximum drawdowns are further reduced over the last 40 plus years. Investors forgot these diversification benefits in the late 1990s and we want to avoid repeating these same mistakes.
Lesson #3 – IPOs and other Popularity Contests
A recent study published in 2018 shows how due to overpricing and speculation associated with initial public offerings, the average returns in first two years lag all other companies by 4.4% in the first year and 8.0% in the second year. If an investor can acquire shares before the offering and sell at the end of the first day, they can do better than average, but investment bankers are highly unlikely to continue to provide new issues to investors known to sell immediately.
Lesson #4 – Rebalancing Portfolios for Risk Reduction
Regular rebalancing of the asset classes is an important component of the long-term success in any portfolio. This process is often ignored by investors. For those that do attempt to rebalance, they often find it difficult because it is the process of selling some of the best performing assets and buying the poorer performing, a process that goes against the emotions of most investors. We’ve found systematic rebalancing of the asset classes is best to be done as often as semi-annually, eliminating all emotions from the process.
Rebalancing at key inflection points can make an even bigger impact. Reducing risk exposure after a period of stock outperformance and buying more stock after a selloff can be difficult for many. We are just wrapping up our fall rebalancing period when we typically add to our equity exposure. This year we are adding less than usual due to a stronger market during the summer months. A chart showing the benefits of rebalancing can be found below.
Lesson #5 - Focus on Planning Concepts rather than Short Term Investment Trends
Those clients we engage in tax and retirement planning are often surprised how much they can benefit by taking steps to maximize their social security benefits, save more tax efficiently, defer and even completely eliminate future taxes and manage / retire current debts more efficiently. We compare this to earning an extra percent or two at the same risk levels and the planning strategies almost always show more benefit to clients. From an investment perspective, we’ve found that what we do to help clients avoid hurting themselves is where we add the most value as well. Of course, we are also heavily involved in the estate planning and implementation of plans after the blueprints are created, but some of these items are easier to quantify than others. Below is how Vanguard quantifies the value of a good advisor, which we feel is worthy of consideration.
Joe D. Franklin, CFP is Founder and President of Franklin Wealth Management, and CEO of Innovative Advisory Partners, a registered investment advisory firm in Hixson, Tennessee. A 20+year industry veteran, he contributes guest articles for Money Magazine and authors the Franklin Backstage Pass blog. Joe has also been featured in the Wall Street Journal, Kiplinger's Magazine, USA Today and other publications.
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