A Brief History of a Stupid Investor

Quick -- take a guess at what will be the best asset to own over the next 10 years.

Ask the average investor that question, and where will he or she look for an answer? That's right -- the returns of the past 10 years. How has investing in the winners of yore worked out? Get ready to put on your bell bottoms, feather your hair, and shake your booty as we look back at investment returns over the past 35 years.

A brief history of chasing assets
Let's say it's Jan. 1, 1980, and an investor is deciding where to invest $10,000 for the next 10 years. He's narrowed down his choices to U.S. large-cap stocks, U.S. small-cap stocks, real estate investment trusts (REITs), international stocks, and commodities. Looking back to 1972 (the first year with complete data on all five assets), he sees these returns:

Our investor says to himself, "The prices of oil and gold are going through the roof!" With the 1973-1974 bear market in stocks still fresh in his mind (remember the "Nifty 50"?) and having read the Aug. 13, 1979, issue of BusinessWeek (cover story: "The Death of Equities"), he decides that "hard assets" are the place to be. He invests all of his money in commodities throughout the 1980s. The returns during the decade were:

Commodities did pretty well, turning his $10,000 into $27,608. Yet that was well behind what international stocks returned. Our hypothetical investor says to himself, "I'd better get on the international bandwagon. Heck, the Japanese just bought Rockefeller Center!" So he invests all his money in international stocks for the 1990s. Here are the returns of the five asset classes during the decade.

Despite one of the greatest bull markets in U.S. history, our investor's portfolio grew to $56,027, barely doubling his money. (That's still better than what happened to the Japanese-led firm that owned Rockefeller Center, which went bankrupt in 1995.) He's nearly brought to tears when he realizes that he'd have almost three times as much if he just invested in an S&P 500 index fund during the 1990s.

So our investor, duly chastened, decides to bring his portfolio back home to the blue chips of the red, white, and blue. Once it was clear the Y2K bug was nothing but sound and fury, he invested his entire portfolio in U.S. large caps in January 2000. You know how this has turned out so far:

Until recent weeks, this has been the century for real estate. As for large caps ... not so much. Our investor's original $10,000 stake has grown to $60,583.

Now, how much would he have if instead of shifting his investments around each decade, he invested equal amounts into each of these assets, and rebalanced his portfolio annually? A tidy $331,482. Furthermore, this portfolio lost money in just four years -- one by just $17 -- whereas our hypothetical investor lost money in six years.

Real-life investing
OK, so our story was a little contrived -- but perhaps not by much. Many studies have shown how investors chase the hot investments, which is a recipe for buying high and selling low. Plus, the hypothetical portfolio I've been discussing could be closely replicated with a collection of exchange-traded funds (ETFs):

Now, that isn't a portfolio I recommend in my Rule Your Retirement service. My model portfolios and system are more reflective of real-life investing, where you're either making regular contributions or regular withdrawals -- and always paying taxes. (You can view our model portfolios as well as create a tailored retirement plan with a free 30-day trial to Rule Your Retirement.)

The point of our tale is that putting all your money into one type of investment can lead to a significantly smaller portfolio. What was "in" during one period might be "out" the next. I call it the "asset hokey pokey," and it can shake your portfolio all about.

If you want to increase your wealth, if you want to protect your wealth, and if you want to parlay that wealth into a long retirement, an intelligently created and maintained asset allocation is the way to go.

This article was first published Aug. 14, 2007. It has been updated.

Robert Brokamp is the advisor of Motley Fool Rule Your Retirement, which you can try free for 30 days. Subscribe today and you can join the "How to Plan the Perfect Retirement" seminar, which started this week.

Robert has been described as both hokey and pokey. He doesn't own any of the companies or ETFs mentioned in this article, but does own several low-cost index funds. Total is an Income Investor pick. Vodafone is an Inside Value recommendation. The Motley Fool has a disclosure policy.