With the close of 2009 we can learn a very important lesson about investing. During the last 10 years, from 2000 through 2009, stock returns, as measured by the Standard and Poors 500 Stock Index (S&P 500), have lost 1.1%. Some have called it the “lost decade”. Some are questioning the wisdom of investing in stocks at all.

The lesson to be learned from the last ten years, however, is that we should continue to include stocks in our portfolios, but at the same time, we must ensure that our portfolios are well diversified and periodically rebalanced. In short, the lesson to learn is that diversification does indeed work.

It’s always dangerous to draw conclusions about investing from a single time period. The last ten years included some extraordinary events. We started off in 2000 with the internet stock craze and bubble followed shortly thereafter by the September 11th terror attack. Low interest rates introduced to counter the ensuing recession helped lead to the real estate crash of 2007 and 2008 and the current economic crisis. It was an extraordinary decade.

History tells us there have been 10-year periods in the past with similar poor stock returns relative to fixed income assets. When we meet with clients to discuss the risks of investing, we review the historical returns of equities and fixed income assets. In the book Asset Allocation by Roger C. Gibson, Mr. Gibson includes historical data on stock and bond returns. A review of all the rolling 10-year periods from 1926 through 2004 shows that in a bit more than 21 % of those periods, fixed income assets performed better than stocks. We can therefore see that the returns of the last decade were not that unusual.

Money Magazine’s January/February Investor’s Guide 2010 shows how investing regularly, diversifying and rebalancing improved returns over the last 10 years. A lump sum invested in the S&P 500, followed by $1,000 a month investments, lost 0.3% over the last ten years compared to the 1.1% loss for the same lump sum investment with no periodic additional investments. The article also showed that a lump sum invested in a diversified 80% stock/20% bond portfolio would have returned 2.9% over the last decade, while a similar portfolio with additional monthly investments of $1,000 would have returned 3.7%. Annual rebalancing further increased returns of the 80/20 portfolio to 3.8%. Three similar portfolios with a 60% stock/40% bond mix returned 3.6%, 3.9% and 4.3%, respectively.

Clearly, the returns of these diversified portfolios were nothing to rave about – but, they were positive returns during one of the most difficult economic decades ever. We are sure there are many investors out there who would have loved to have achieved similar results.

There is no guarantee that we will experience similar results in the future but unless someone can convince us of a better approach, we will continue to recommend broadly diversified stock/bond portfolios with periodic rebalancing. Don’t give up on stocks yet, but don’t shun bonds either.