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Investing: What We've Learned This Century

Five things the first 16 years of the 21st century have taught us

asset class performance chart

The first 16 years of this century have taught us a lot about investing.

As of the end of 2016, the three main classes of investments, as measured by the following index funds, have had the following average annualized total returns, including reinvestment of dividends:

  • Vanguard Total Stock Market Index Fund (VTSMX), 4.92%
  • Vanguard Total International Stock Index Fund (VGTSX), 2.72%
  • Vanguard Total Bond Market Index Fund (VBMFX), 4.98%

While the past isn't indicative of the future, these five takeaways are likely to help you with your investment decisions going forward.

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1. Understand that stocks are risky and invest accordingly. For the past decade, I've been hearing about a so-called bond bubble. If interest rates soar, bond prices will fall. That's hard to reconcile with the wild ride stocks have had, compared with the stability of bonds. Although trying to predict future stock performance is an exercise in futility, it's easier to predict with near certainty that bonds will have far less volatility than stocks in the long run. As I remind my clients, stocks are riskier in a day than high-quality bonds are in a year.

2. Understand how long your long run is. Stocks for the long run can be longer than you can wait. We all know that stocks are for growth and that, in the long run, stocks outpace bonds. I agree with this, yet the long run can be well over a decade. For instance, in the past 17 years, bonds have slightly outpaced U.S. stocks and trounced international stocks.

3. Don't invest based on the recent past. Neither good nor bad times last forever. Over the five-year period ending in 2007, U.S. stocks doubled while international stocks tripled. I wish I had a dime for all those who told me then that they had a high-risk tolerance and that international stocks were sure to outperform U.S. stocks. A year later, in the wake of the financial sector meltdown, and in the midst of the Great Recession, some of those same people had changed their tune to "Cash is king" and missed out on the also-great recovery. If you think this current eight-year bull stock market will continue indefinitely, you may someday find yourself wishing you had a time machine to rethink that premise.

4. High-quality bonds act as a shock absorber and give you the ability to rebalance your investment portfolio. Rebalancing worked and likely will continue to work in the long run. Despite the benefits of buying stocks when they are on sale, few investors had the intestinal fortitude to do it when stocks plunged in 2002 and especially in 2008. Sticking to just about any asset allocation — a set percentage in stock and a set percentage in bonds — would have worked, as it meant one would have to sell after stocks surged and buy after a plunge to get back to one's target allocation. Just make sure they are high-quality bonds or bond funds. According to Morningstar, the average taxable bond fund lost nearly 8 percent in 2008, but that average included many risky bond funds, such as high-yield junk-bond funds, some of which lost 20 percent. The bonds in the bond fund in this graphic above are mostly backed by the U.S. government. The fund gained 5.05 percent that year. Though bonds aren't likely to continue performing as well as they have so far this century, don't bail on them. Sell some only to rebalance your portfolio after bonds have outperformed stocks.

5. U.S. stocks don't provide enough international diversification. It seems to be a common perception, and I've certainly heard it said often enough, that because so much of the revenue of major U.S. companies comes from overseas, there is no need to own international stocks. But look at how global stocks trounced U.S. stocks in the first half of the 17-year period and badly underperformed in the second half. You wouldn't see such divergences in performance if U.S. stocks alone gave enough foreign exposure. Regardless of whether international stocks outperform U.S. stocks this year (they do have a slight lead so far) or just the opposite, I still want to own the entire world.

Investing in the 21st Century

What has living in the modern world taught us about investing?

It's doubtful that the next 16 years of investing will mirror the past. But applying what we've learned during that period through these five lessons will give you an advantage in future investing.

Allan Roth is the founder of Wealth Logic, an hourly based financial planning firm in Colorado Springs, Colo. He has taught investing and finance at universities and written for Money magazine, the Wall Street Journal and others. His contributions aren't meant to convey specific investment advice.