Experience is the best teacher, but only if you learn from it.
I had the misfortune of entering the financial advisory industry in the late 1990s, just 19 months before one of the biggest stock market declines in the last century. But for that first year-and-a-half, it was smooth sailing. In those days, fresh out of college, I was what we used to call a stock broker, although my PaineWebber (now UBS) business card had a fancier title: Account Executive. For a time, it felt like I earned that executive title; everything I sold people went up because a rising tide lifted all the boats. Between September 1998 and March 2000, the S&P 500 Index went up 60%, and the Nasdaq Index, which back then, like now, was almost all tech stocks, went up 205%! It felt like printing money; I couldn't miss. It was like my college basketball career had never ended.
And then the music stopped.
From April 2000 through September 2002, the S&P 500 declined almost 44%, and the Nasdaq dropped over 74%. For the S&P 500, this was the worst decline since the 1973-1974 bear market before I was born. To find a period when a stock index dropped by as much as the Nasdaq did, you must trace the S&P 500 Index back to the Great Depression. I had no idea stocks could fall that much. Even the biggest blue chip stocks of the day, Microsoft, Cisco, and Intel, got crushed, losing 59%, 86%, and 79%, respectively. Although not a household name at the time, Apple stock dropped 79%. Amazon, back then just an online bookstore, was down over 91%. It's hard to put into words how bad it was.
I learned far too late that the magnitude of these declines weren't necessary. The 2000-2002 bear market wasn't a market-wide collapse, but instead, a steep decline concentrated mainly in one part of the market—large cap growth stocks, of which many were internet and dot-com companies. The same stocks that were red hot in the late 1990s were the ones hit the hardest in the early 2000s. It was my introduction to the notion that the stock market isn't just one homogenous group of companies, but there are different types of stocks, or "asset classes" within the stock market.
What Goes Up Will Come Down
What I saw during the dot-com bust astonished me. Unlike the roller coaster ride that higher-priced growth stocks had been on, cheaper, lower-priced "value" stocks held up much better during the 2000s decline after not rising as fast in the 1990s. Between April 2000 and September 2002, large value companies only lost 5% and small value companies gained 4.9%. Talk about an investment life preserver!
Had I better understood asset class investing, I could have reduced client losses by diversifying their stock portfolios beyond large growth companies. I vowed never again to let clients concentrate all their investments in one asset class, no matter how well it had done recently or how bad their FOMO, or fear of missing out, got.
Still, some questions remained. I was recommending globally diversified portfolios because, in theory, international developed and US stocks were supposed to have the same long-term returns. However, their short-term results should diverge, providing a diversification benefit for a global portfolio. But all I had seen was US stock outperformance in the 1990s and smaller declines during the 2000-2002 bear market. Did we need to diversify globally?
It took the recovery that began in late 2002 for me to experience the benefits of owning international stocks. From October 2002 through June 2007, while the S&P 500 Index returned +15.8% annually (the Nasdaq did +18.3% per year), the international MSCI World ex-USA Index gained +23.9% yearly. US large and small value stocks continued the outperformance that began during the bear market, returning +20.6% and +25.9% per year. However, international large and small value stocks gained the most, returning a red-hot +30.9% and +34.9% per year, respectively. When international stocks performed well, large and small value asset classes were supposed to do best. This had undoubtedly been the case.
By 2007, international stocks had surpassed the return on US stocks for as long as I had been an advisor; I was sold on global diversification. In fact, I remember working hard at the time to keep clients from going overboard with international stocks—some wanted to put 50%, 60%, or more in companies outside the US. The affinity for emerging markets was rampant, especially Brazil, Russia, India, and China (the "BRICs"). Trust me, performance chasing is not a recent phenomenon.
More Lessons
What happened over the next seven years is still fresh in many people's minds. There was the brutal bear market that began in late 2007 and ended in early 2009, in which all stock asset classes dropped by over 50%. This time, stock asset class diversification couldn't help, as only short-term bonds managed positive returns (the DFA Five-Year Global Bond fund gained 7% over this period). Next was an equally strong five-year recovery in which international large and small value stocks came out of the gate fastest, followed by a rotation back to US large and small value stocks. It took about two years for most stock asset classes to recover their 2008 losses, and by the early 2010s, stocks were higher than they had been in 2007.
By mid-2014, it seemed to me that any questions about how to invest could be put to rest. I had been investing people's money for almost 15 years, and we had nearly two decades of live DFA asset class mutual fund returns (starting in 1995); both periods perfectly corresponded to what the long-term academic evidence suggested. Large and small value stocks clearly had higher expected returns compared to growth stocks and the overall market, and the same patterns existed in international stocks (small and value beat large and growth). Although unpredictable, the cyclical shift back and forth between US and international stock leadership made diversifying globally a no-brainer. DFA funds had proven uniquely adept at capturing these value and small cap value stock premiums compared to traditional active and index funds. Sure, US large growth stocks had an unexpectedly good run for a few years in the late 1990s, but the crash that ensued was so monumental that I couldn't imagine anyone would return to those pre-2000 days when the S&P 500 and Nasdaq were all anyone wanted. Who would sign on for what could be an 80% crash on the other side of another bubble?
Unfortunately, we learn from history that we don't learn from history.
The last ten years look almost identical to the 1990s. Cisco, Intel, and Sun Microsystems have been replaced by Apple, Amazon, Google, Facebook, and, more recently, Nvidia as the high-flying large growth stocks of the day. The social media and artificial intelligence mania has replaced the dot-com boom. Since July 2014, the S&P 500 Index has returned 12.1%, and the Nasdaq Index almost 14% yearly. On an absolute basis, those aren't stratospheric, but on a relative basis, they are. On the other hand,US large and small value stocks are up only 8.4% and 7.5% per year, and international value and small value stocks have returned less than 5% annually. "Dot.com or bust" has been replaced by "S&P 500 (or Nasdaq/QQQ) and chill" as the investing mantra of the day.
Market leadership does seem to have changed back to US large and small value stocks since the end of 2020; they've returned +15.8% and +23.1% per year compared to +9.9% for the Nasdaq and +13.7% for the S&P 500 since October 2020, but that hasn't been enough to erase the disappointment and underperformance for small and value that we've seen over the last decade. What's more, after value stocks significantly outperformed in 2021 and lost a lot less in 2022, last year and the start to 2024 has seen a shift back to growth. I sense that there's still a lot of frustration going around.
Realizing all of this, clients naturally have two questions: What should we do about this trend of US large growth outperformance, and why have we once again seen what some are calling a bubble in large growth stocks? I will handle the second question in a follow-up article and instead focus on "what do we do" in the rest of this one.
I understand there is a natural inclination to abandon broad asset class diversification, with the 10-year returns for US large growth stocks—the S&P 500 and Nasdaq, for example—so high compared to anything else. It feels like you're missing out. It feels like 1999 all over again. But I think changing course at this point could be a huge mistake.
I've seen what happens when people chase investments that have recently soared and generated returns well above their long-term averages or done much better than everything else. The declines that large cap growth and tech stocks experienced in the early 2000s were devastating, as was an entire decade (2000-2009) when the S&P 500 and Nasdaq Indexes lost money. It's not a guarantee that we'll see a repeat performance, however similar the run-up has looked. But why risk it?
Every Servo client invests according to a plan that stipulates a return goal on their savings. While everyone has a different goal, I know for a fact that no one can be successful with a 0% or worse return over an extended period. Betting big on yesterday's winner could mean you're stuck with tomorrow's biggest loser.
So, how should we think about the current environment?
First, understand that you are participating in the large growth/tech stock run-up in a part of your portfolio.The DFA US Large Cap Equity fund and Dimensional US Equity ETF common in portfolios hold all of these high flyers—they are our diversified "large growth" funds. It's why they're up so much in the last few years. But we're not going to go 100% into these funds. We still want own other stocks and other asset classes as well. That's called being diversified. The time will come for today's ugly ducklings; large and small value stocks in US and international markets will likely do well when we need them to, not when US large growth stocks are far exceeding their long-term average.
Next, ask yourself, how long can this trend continue, and what's the real expected long-term return for growth companies? For the ten years that ended in March, the Fama/French US Large Growth Index—which you can think of as a more diversified Nasdaq Index with a 90+ year history—has averaged a whopping +15.6% per year. What had it done in the prior eight decades? Just +9.3% per year. The DFA US Large and Small Value funds returned just +9.3% and +8.4% in the last decade. However, looking back over the same period from 1927 to 2013, when the US Large Growth Index did +9.3%, we see +11.4% and +13.8% returns for the Dimensional US Large and Small Value Indexes. Simply put, US large growth stocks are way out over their skis in terms of recent returns, while value and small stocks have come in below their long-term averages. Could the next decade see a reversal? Do you want to bet everything you have on that not happening? I believe the long-term average is a much better barometer of future returns than what we've seen recently.
The fact is, there have been decade-long stretches before where large growth stocks had well-above-average returns. I looked at stock index data over all 10-year periods starting in 1928 and found that large growth stocks had returns of over +15% per year for a decade about 17% of the time. Not common, but not unheard of. Guess what their returns were in the following ten years after the big runs? +9.0% per year. In line with their long-term average. The above-average returns didn't continue. What about large and small value stock index returns over the following ten years after a large growth surge? Also in line with their averages—+11.2% and +15.3% per year, respectively. And much better than large growth.
What’s Working vs What’s Always Worked
I lived through the boom and bust of large growth stocks in the late 1990s and early 2000s. Clients I had lost a lot of money unnecessarily, including friends and even my mom and dad. Numbers on a screen can't do justice to the frustration that people felt. I swore that I wouldn't allow clients under my care to experience the same avoidable catastrophic meltdown again. I had been fooled by the temporary abnormal gains in growth stocks and vowed not to repeat the same mistake.
Fool me once; shame on you. Fool me twice; shame on me.
What should we do in light of the last ten years? Stay balanced and globally diversified. Continue to emphasize where we know higher stock returns have come from in the long run—value and small cap companies—and not read too much into just the last ten years. It's different this time, you think? It's always been different at the time, yet these core investing principles have endured; they've stood the test of time. That's why we can have confidence that they are worth sticking to.
I'm not about to get fooled again.
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Past performance is not a guarantee of future results. Index and mutual fund performance includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or additional expenses except where noted. Indexes and mutual funds shown are for illustrative purposes only and may not be the only or any of the funds that Servo clients hold. Servo was not managing client portfolios over the entirety of the periods shown. This content is informational and should not be considered an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.