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.
Showing us what conditions looked like from a 2001 point-of-view works well to remind us that the events of the last decade were not inevitable and obviously going to happen. They only look obvious in hindsight. Nice post.
Excellent post. However, I doubt that this type of argument will satisfy your detractors. I suspect that they would state that they “knew” that the US housing market would decline, or that the financial sector had overextended itself, or any other sort of miraculous predictions a la Biff Tannen.
All’s clear when you’re resting at the summit of Delphi.
I just went back and read Robert Shiller’s Irrational Exuberance, which actually is very prescient. The problem for the investor, however, is knowing who to listen to. There were a lot more people reading Dow 36,000 at the time, and that sounded just as convincing. Remember the underlying reason for the tech bubble: people thought that the Internet would fundamentally change the economy. Boy, were they ever wrong! Oh, wait a minute…
I remember those days. Everyone thought the Old Economy was toast and the New Economy was going to eat its lunch. Funny how within a year or two, the oldest economy stocks you can think of — mining and energy were the best performers. How many saw that coming? And why would they think they’ll be able to see the next big thing coming?
@CC: I think the answer to your last question is, “Because we are human.” As Raman points out above, it doesn’t matter if you can demonstrate that the future could not have been predicted: hindsight bias will always persist.
Great reminder – the future is uncertain; stick to your strategy.
You leave out an important stat, right at the end. What was the return of the “globally diversified portfolio” over the same time period?
@Pacific: The Global Couch Potato performance was 4% for the decade. There is no decade-long performance record for the real-world Complete Couch Potato, because the products have not existed that long, and I just created that portfolio a couple of years ago.
It would have done better than 4% based on the index returns, but once you start going down that road you fall into the same trap. My point is not that the Complete Couch Potato would have been ideal for 2001-10, but that it provides the broad diversification you should look for during all periods.
Excellent post. I think this is one of your ‘pillar articles’ in relation to the couch potato strategy and I really like how the content flows nicely to your report card & model couch potato portfolios.
Your couch potato report card for the Global Couch potato doesn’t lie, and if I were an investor that wanted a laissez-faire portfolio, top up and do basic maintenance from time to time, I’d certainly be happy with that kind of a return – especially with so much volatility over the past 10 years.
I like how none of your model portfolios have an overall or weighted MER that exceeds 0.50%. If I were to exclusively embrace one of the model portfolios, I would definitely choose a Couch Potato portfolio with ETFs rather than index mutual funds.
Great job!
Brilliant! A great reminder ;) and very well written.
So many people are eager to pull out the “it’s a different economy” or “it’s a balance sheet recession this time” or a “secular bear recession” or “bonds are dead”, or whatever other theory they can think of. These were the same pundits that were preaching not to hold any bonds a few months ago. This happens like clockwork, every time markets get overheated and take a dip or a turn.
I wonder what the next value play will be. Fortunately as an index investor, you don’t really have to figure it out.
The next bag of Cheetos is on me :)
Nice post Dan.
So many investment lessons can be learned from history, whatever the future may hold.
Your article nicely reinforces the point that a diversified portfolio, with low-cost, broad-market ETFs can ensure many investors have all the necessary clothes packed to handle all sorts of market weather one might encounter during their hike towards retirement. I’m trying to apply this very approach in my RRSP thanks to blogs like yours.
@Wealthy Canadian, Ninja, gsp and MOA: Glad you found this reminder helpful. I think we all need to turn back the clock every now and then and ask ourselves, “Could we really have foreseen what happened over the last several years?”
I realize I didn’t even mention Nortel: from one-third of the TSX in 2002 to bankrupt in 2009. Of course, everyone knew that would happen. It was “obvious.”
@CCP: I hear you regarding Nortel. When I heard the other day that there was an auction for their numerous patents (I believe it was a mix of 6 companies led by Apple that were victorious), it gives us a grim reminder of what can happen.
One useful lesson that’s probably fair to take from the last 10 years is the importance of diversification (particularly in tumultuous markets).
The more asset classes one had mixed into their portfolio over the last 10 years, the better one tended to do, particularly with rebalancing. TIPS/RRBs, emerging market bonds, high yield bonds, emerging market equities, small cap equities, REITs, commodities, and gold all outperformed the standard two asset classes (core bonds and large cap equities). That’s not to say this will happen again, though the odds currently look good.
Nice post and historical summary… wonder what will come over the next 10 years! Rebalancing and diversification is the way that I prefer as well.