Research

Three Investment Maxims from Vanguard's CEO

William McNabb - January 30, 2009.

When I opened my first money market mutual fund account in the early 1980s, yields hovered in the teens. Within a few years, the era's high inflation was tamed and money market yields retreated to the single digits more typical of short-term, fixed income instruments.

And yet, until I arrived at Vanguard and became a student of market history, those initial yields were a powerful influence on my expectations about earnings on low-risk savings. When I meet Vanguard clients who began investing during that era, I often hear the same thing. For a while, at least, we were prisoners of our experience.

Challenging our personal expectations

I see the potential for the same thing to happen among today's stock market investors. Many of today's investors started investing in the 1980s or 1990s. Over that two-decade span, the stock market posted an average annual return of 17.9% (as measured by the Standard & Poor's® 500 Index). That's a tremendous result, but one that may have set unrealistic expectations for the long term.

Newer investors may have entirely different expectations. Think of a 30-year-old who opened a 401(k) account at the beginning of this decade. That investor's stock portfolio experienced parts of two steep bull markets and two steep bear markets in the course of only nine years. On average, stocks have returned -3.6% per year since 2000 (December 31, 1999, through December 31, 2008). It's been a remarkably volatile and largely disappointing period in the financial markets, and for most young investors, it's all they've known (sources: Vanguard and S&P 500 Index).

 But investors should not set expectations for the long haul based on the stellar returns of the 1980s and 1990s or on the market's poor performance since then. Over much longer periods, returns in the financial markets have been quite respectable. In the 82 years of the stock market's modern era (dating back to 1927), stocks have posted an average annual return of 9.6% (through the end of 2008).  There's no reason to expect future long-term results to be significantly higher or lower than their historical averages (sources: Vanguard and S&P 500 Index).

 Note: Returns for the S&P 500 Index prior to its March 4, 1957, inception were extrapolated back in time.

 It's helpful to look at investing in stocks as taking an ownership stake in the American economy. In the short term, market returns are largely driven by investor sentiment. But in the long run, the market has served as a reliable yardstick of corporate output (earnings and dividends) plus inflation. There are a lot of questions about the health of the economy in the near term, and rightly so. But throughout history-good times and bad-our economy has proven both industrious and resilient. And I don't believe that will change.

Lessons from a tough year

 While short-term performance can distort long-term expectations, even the briefest periods can provide insights that make us better investors. In 2008, some of these lessons felt like they were delivered with a sledgehammer. Major banks collapsed, the economy faltered, and the U.S. stock market took a white-knuckled ride to a -37.0% return.

I'd like to share three timeless lessons that were reaffirmed in 2008. In Vanguard's tradition of efficiency, these also make good financial resolutions for the rest of 2009 (and beyond):

1. Respect risk. Investments with the potential for great returns also carry great risks. It's tempting to only look at one side of the equation. This was perhaps the most obvious lesson learned during 2008, when risky and complex investment strategies failed en masse. Unfortunately, this lesson gets forgotten in every investment boom and relearned in each ensuing bust. That makes this advice seem too late-but, in reality, it can help us respond to the recent setback and keep us alert when investors once again fail to appreciate the market's true risks. If you've suffered a significant decline in your investment portfolios, you may be tempted to look for ways to play "catch up." Don't. Simply put, you can't invest your way out of a low account balance. And it's dangerous to try.
2. Save aggressively. For 2009, I'm more convinced than ever that investors of all types need to save aggressively, or even "over-save." The sad truth is that Americans have been relatively poor savers in recent years. It can be hard-and discouraging-to save and invest money during a market downturn. The thinking often goes, "Why put money in the stock market when it's been posting poor results?" But it may be wiser to ask, "Are you better off making contributions to your retirement account when the Dow Jones Industrial Average is near 8,000 points (where it's been recently) or near 14,000 (where it peaked in October 2007)?"
3. Be balanced and diversified. Creating a portfolio with a mix of different asset classes (stock, bond, and money market funds) is critical to limiting volatility. Maintaining the appropriate mix (based on your risk tolerance and time horizon) is critical to ensuring that your portfolio continues to reflect your risk and return parameters through good markets and bad. But this discipline can be uncomfortable. Many of Vanguard's own balanced funds, for example, are required to maintain a certain ratio between their stock and bond holdings. That often means that when their stock portfolios perform well, the fund managers must buy bonds; when stocks do poorly, they must buy more stocks. It feels counterintuitive, and from an emotional standpoint, it can be a challenge for many investors. But it's a sensible approach that, over time, has produced solid results. I noted above that stocks have averaged an annual return of 9.6% over the past 82 years. A hypothetical portfolio* consisting of half stocks and half corporate bonds would have averaged an annual 8.2% over that same span.

Timeless principles never go out of style

 Of course, many other enduring investment principles rang true in 2008: Keep your costs low. Stick to your long-term plans. Invest with a trustworthy, prudent, and stable provider. These principles have long been valued by Vanguard investors, and it showed in 2008. Our clients remained loyal to Vanguard and true to their long-term strategies.

 As personal experiences go, few investors will forget the sting of 2008. And the level of economic and market uncertainty remains high in 2009. But try to put these experiences in a broader context. Our experience is influential and even instructive, but it's not necessarily predictive, as those who entered the mutual fund industry in pursuit of double-digit money market fund returns learned in the early 1980s. And at some point I think we'll recognize that the historic bull market of the 1980s and 1990s and the dismal returns of the past decade are similarly unreliable long-term anchors.

 In the meantime, the best we can do is maintain a prudent approach and bear in mind the lessons we learned in 2008-timeless investment principles that never go out of style. We thank you for your continued trust and loyalty.

 *This example is based on a portfolio consisting of 50% stocks (S&P 500 Index) and 50% corporate bonds (S&P High Grade Corporate Index from 1927 through 1968; Salomon High Grade Index from 1969 to 1972; Barclays US Long Credit Aa thereafter.)

 Notes

• Investments in bond funds are subject to interest rate, credit, and inflation risk.
• Diversification does not ensure a profit or protect against a loss in a declining market.
• All investments, including a portfolio's current and future holdings, are subject to risk
• An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund. Notwithstanding the preceding statements, the funds are participating in the U.S. Treasury's Temporary Guarantee Program for Money Market Funds. The Program generally does not guarantee any new investments in the funds made after September 19, 2008, and is scheduled to expire on April 30, 2009. For more information, please see a fund's most recent prospectus as supplemented on December 2, 2008.
• The hypothetical example does not represent the return on any particular investment.
• Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.