There's little doubt that the past five years have been good to investors. The stock market has climbed out of the hole it dug for itself in the bear market of 2000-2002, and bonds have also done remarkably well. However, it's important to remember that the market doesn't owe investors double-digit returns year after year. Periods of lower or even negative returns often follow lofty gains. Don't look now, but a gray cloud of slower returns may be appearing on the horizon.
Making progress
A quick look at the performance of several different areas of the market over the past five years confirms that returns have generally been impressive.
|
Market Index |
5-Year Cumulative Return through June 2007 |
|---|---|
|
S&P 500 Index (Large-Cap Stocks) |
66.3% |
|
Russell 2000 Index (Small-Cap Stocks) |
91.5% |
|
MSCI EAFE Index (Foreign Stocks) |
126.2% |
|
LB Aggregate Bond Index (Bonds) |
24.5% |
While certain areas have outperformed others -- most notably emerging markets and small-cap value stocks -- all corners of the market have benefited from the past few years' economic and market rebound. But it might be awhile before we see these types of gains again.
The downside of an up market
While a bull market is a good thing for investors, the drawback is that prices are driven up, making everything more expensive, and making attractive buying opportunities more scarce. Bonds have benefited from years of low interest rates, and stocks have been boosted by buybacks and buyouts, leaving them less attractively priced. That means that stock pickers and fund managers will likely find fewer bargains today than they did five years ago.
Of course, this is not to say that these managers will be sitting idly on their hands until the next market drop. There are still some opportunities out there, but an inflated stock market makes the stock-picker's job that much harder. All the low-hanging fruit has been plucked, which will likely translate into more subdued returns for investors going forward.
Lowered expectations
So what's an investor to do? First of all, remember that there's no need to run for the hills -- the sky isn't falling. A period of subdued returns is vastly different from a bear market. The stock market has its ebbs and flows, and smart investors must know how to ride out these fluctuations.
Ultimately, individual investors can do little to prepare for slower returns, aside from knowing that they're coming. Market prices are what they are, and you can only buy or sell at the prices available. Position your portfolio for the long term, which for most people means including a healthy slug of equities. Right now is a great time to load up on some defensive stocks, such as Unilever (NYSE:UL), that should hold up well in a downturn. But you might also want to consider high-quality growth stocks with solid earnings, which can work their way through a slowdown. While many value stocks that are traditional defensive plays have risen dramatically in recent years, solid growth companies like Cisco Systems (NASDAQ:CSCO) and Time Warner (NYSE:TWX) aren't trading at unreasonable valuations.
Since picking stocks will likely become much more difficult over the next few years, consider moving into a diversified mutual fund. Let the experts take the time and effort of uncovering those hidden values and putting them to work for your portfolio. Since a rebound in growth stocks is very likely at some point this year or the next, make sure you have a healthy allocation to a fund that invests in this corner of the market.
Just knowing that returns probably won't be as spectacular in the immediate future puts you one step ahead of much of the investing public. Adjust your portfolio assumptions accordingly -- don't bet the farm on earning a 20% return for the next five years. And don't beat up on any of your fund managers for failing to provide a repeat of the past few years' performance. While it may be slim pickings in the coming months or years, remember to keep your focus on the long term, and try not to sweat the lows too much. Odds are good that we'll be back in the sunshine again before long.
No matter how the market performs in the coming months and years, certain funds can offer the best chance of making you the most money. Discover our favorite picks with a free 30-day trial of the Fool's Champion Funds newsletter.
Fool contributor Amanda Kish lives in Rochester, N.Y., and does not own shares of any of the companies or funds mentioned herein. Unilever is an Income Investor recommendation. Time Warner is a Stock Advisor pick. The Fool's disclosure policy is equally fond of tortoises and hares.
