Forget about the Lost Decade. Historical performance figures for the stock market just got a huge bump, and investors have started piling into stocks again. It could be coincidence, but the emergence of what one might call the "Found Decade" only reflects the trap you can fall into by focusing too much on historical return figures.
The perils of 10-year performance records
One of the basic tenets of investing is that you can't rely on past performance as a gauge of future results. In practice, though, investors pay lots of attention to past return figures, making them a critical element of the methods they use to decide when to invest and which investments to buy.
Most investors understand, though, that using long-term return figures to evaluate performance makes more sense than shorter-term return tracking. Looking beyond the past month or year inevitably gives you a more complete picture of how well a strategy works through a variety of different market conditions. That's why so many investors choose to look at a 10-year track record to determine whether a given strategy is working.
But as a recent analysis from Vanguard showed, changes in 10-year track records are extremely misleading right now. Even though trailing return figures have increased greatly, the big reason for the shift has more to do with returns from 2002 than with 2012's results.
What Lost Decade?
The origins of the Lost Decade concept go back to 2009. During the depths of the financial crisis, investors looked back at the failure of major stock market benchmarks like the S&P 500 to deliver positive returns over the preceding 10 years. They used those figures to conclude that the stock market was a bad investment, and for the past several years, many investors have avoided stocks entirely, choosing bonds and other asset classes with better trailing performance figures.
At the time, I noted that it was unfair to look back 10 years from an obvious low point for the markets and the economy in 2009 to the booming, bubble-like conditions that prevailed at the end of the bull market in 1999. Yet now, the situation is similar, but the unfairness comes from the reverse conclusion.
If you only looked at returns from the past 10 years as of the end of 2012, you wouldn't see evidence of a Lost Decade at all. U.S. stocks have gained an average of 8% from the beginning of 2003 to the end of 2012, while international stocks did even better, returning almost 11% annually over the time frame. Those figures are extremely close to the long-term historical returns of around 9% to 10%.
Yet it's no fairer to look at today's trailing returns from 2003 to 2012 than it was to focus on the Lost Decade returns of 2000 to 2009. At the end of 2002, the market had suffered through its worst bear market in decades, sending stocks to ridiculously low levels. In the inevitable bounce in 2003, stocks gained more than 30%.
In other words, having drawn too-pessimistic conclusions from lost-decade comparisons, you shouldn't draw too-optimistic conclusions by measuring from the low levels of 2002 to the near-record-highs of today. The right answer lies somewhere in between.
Pick smart investments
But there's a better lesson to draw from the trailing-return fallacy: Owning a wide array of investments can help you avoid long periods of flat returns.
Even during the Lost Decade, Vanguard Total Stock Market (NYSEMKT:VTI) and other large-cap-heavy investments bore the brunt of the unfavorable returns. When you looked instead at the iShares Russell 2000's (NYSEMKT:IWM) small-cap portfolio, you saw a much different performance figure, with more extensive gains. Similarly, going abroad, Vanguard Emerging Markets Stock (NYSEMKT:VWO) put in much better performance than the S&P 500.
Moreover, having other investments besides stocks helped most investors weather the storm. Vanguard REIT Index (NYSEMKT:VNQ) and its index mutual fund counterpart provided solid returns during the period. Bonds also performed well, with iShares Core Total US Bond (NYSEMKT:AGG) providing reasonable total returns.
Don't be misled
It's essential to keep perspective when you're looking at investments. Rather than simply picking one benchmark and one time frame in which to evaluate it, look instead at the bigger picture, making sure to incorporate all the ups and downs of a given type of investment. Only then will you be able to make a truly informed choice about whether it's a good buy right now.
Fool contributor Dan Caplinger owns shares of Vanguard Emerging Market Stock and iShares Russell 2000. You can follow him on Twitter @DanCaplinger. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.