This has been a scary few months in the markets, and nervous investors may be tempted to second-guess their strategy. If you’re an indexer, you may be starting to believe that it’s time to reposition your portfolio for the changes that are “certain” to come. Depending on which guru you listen to, that might be high inflation, rising interest rates, a double-dip recession, the collapse of the U.S. dollar, or a long period of poor equity returns. The voices are all shouting at you: this is not a time to be passive!

I thought it would be interesting to put ourselves in the mind of a Canadian investor on January 1, 2001, the start date of the 10-year period I looked at in my Couch Potato report card. You’ll recall that this simple portfolio returned 4% annually during that period, a result that most people would agree was disappointing, even though it beat 86% of comparable mutual funds.

2001: An Investor’s Odyssey

Based on what you knew about the economy and markets in 2001, could you have built a portfolio that would have done better? As you woke up with your New Year’s Eve hangover, here’s the environment you’d have found yourself in:

  • Although the dot-com craze was rapidly cooling and stocks had negative returns in 2000, the annualized 10-year return of the S&P 500 was still 20.5% in Canadian dollars. The S&P/TSX Composite was a dog by comparison: it returned about 13% annualized during the same period.
  • Emerging markets, the darlings of the late 1980s and early 1990s, were an embarrassment, with negative returns for the seven years from 1994 through 2000.
  • If you had bought $1,000 worth of gold 20 years earlier (in 1981) it would have been worth $585 (in Canadian dollars), before adjusting for inflation.
  • The price of oil was under $27 USD a barrel and would fall even lower as the year went on.
  • The Canadian dollar had declined steadily from $0.88 USD in October 1991 to $0.65 USD at the beginning of 2001.
  • Short-term interest rates had been trending steadily downward for years. The return on 90-day T-bills was over 13% in 1990, declining to barely 3% in 1997, before levelling off around 5% over the last three years of the decade.
  • Despite this trend of declining short-term rates, recent returns on the overall bond market were about double the historical average. The Scotia Capital Markets Bond Index (the predecessor of the DEX Universe) returned over 10% annualized from 1991 through 2000.

What was the sentiment like at the time? For a clue you can read the speech delivered in January 2001 by Gordon Thiessen, then governor of the Bank of Canada. He concluded his talk with an optimistic nod to “the improvements we have seen in the fundamental, longer-term trends in our economy. Because of these improvements, our economy is now in better shape than it has been for some time to deal with all kinds of external shocks.”

Didn’t see that coming

Now let’s review how things actually played out and decide whether our investor in 2001 might have been surprised by a few things:

  • Eight months after Thiessen declared us ready to “deal with all kinds of external shocks,” terrorists crashed hijacked planes in to the World Trade Center and the Pentagon and the U.S. and its allies, including Canada, went to war with Afghanistan.
  • The markets plunged in 2001 and 2002 as the dot-com bubble deflated.
  • In March of 2003, the U.S. began a second war in Iraq. Oil prices would quadruple by 2008.
  • After the dot-com disaster, the next four years (2003 through 2006) saw a raging bull market almost on par with the 1990s: 15% annualized returns in the U.S., and over 20% in Canada.
  • The Canadian dollar began a remarkable climb, peaking at $1.10 USD in November 2007, falling back to $0.77 USD in 2009, and then touching $1.06 USD again in 2011.
  • Gold doubled in value (in Canadian dollars) from 2006 through 2010.
  • The financial crisis of 2008–09 saw some of the world’s largest financial institutions collapse and caused stock-market declines of 40% to 50%, leaving many people to ponder if the global financial system might collapse completely. Then the markets recovered rapidly from the crisis, returning 80% to 90% from March 2009 to the end of 2010.
  • The best-performing equity asset class for the decade was emerging markets, which delivered over 11% annualized.
  • Interest rates continued to fall, with short-term rates approaching zero in 2009.

The future: Still crazy after all these years

Which of these events could have been anticipated the day that Gordon Thiessen delivered his speech? More to the point, what would have been a reasonable strategy for a Canadian investor assessing market conditions in early 2001?

Well, you would have been a big winner if you had completely abandoned the best-performing asset class of the previous decade (U.S. stocks), embraced others (gold and emerging markets) that had been horrendous for many years, and bet that the pathetic Canadian dollar would increase by about 60%. For good measure, you might have also shorted the U.S. housing market.

Or you might have recognized that it is absurd to think we can predict how the future will unfold, and instead built a globally diversified portfolio equipped to weather anything the market sends its way. It should include thousands of stocks, in all sectors, from dozens of countries, in several currencies. Throw in government bonds of all maturities to provide ballast when equity markets are volatile, and inflation-protected bonds, real estate, and some exposure to commodities.

This kind of strategy carries no guarantee of absolute returns. It simply captures everything the markets have to give, which is all any investor can hope for—unless you believe you can do better with your predictions for the next decade.