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'Lost Decade' Shows It Pays to Diversify

The S&P 500 fell an average of 1% a year for the past decade. But 51 of 55 investment categories gained, suggesting diversification is the key.

BOSTON (TheStreet) -- During the past 10 years, the S&P 500 Index dropped 1% annually, marking a lost decade of sorts. But while blue chips sank, other segments stayed afloat.

Of the 55 mutual-fund categories tracked by Morningstar, 51 produced positive returns during the past 10 years. Top fund categories include natural resources, which returned 13% annually for the decade, and small value stocks, with a return of 8.6%.

Among overseas categories, only

Japan mutual funds

lost money.

Latin America mutual funds

led the way with returns of 16%, while

European mutual funds

returned 4.9%.

In a decade of many surprises, bonds produced predictable results.

Intermediate government mutual funds

returned 5.3% annually. That almost exactly matched the long-term average for government bonds, according to Ibbotson Associates. The most notable fixed-income overachievers included

emerging-market bond mutual funds

, which returned 11%, and

inflation-protected bond mutual funds

, with a return of 6.4%.

If so many funds rose, why did the S&P 500 fall? The poor showing of blue chips can be traced to the plain fact that they were overvalued at the beginning of the decade.

In the late 1990s, investors poured into large growth stocks. By the time the market peaked in 2000, technology and financial shares posted rich price-to-earnings ratios.

After technology stocks began crashing in the spring of 2000, they went into a long funk. For the decade,

technology mutual funds

lost 6.8% annually. Dragged down by technology,

large growth mutual funds

lost 2.1% annually.

Small-cap mutual funds

followed a very different path. Overlooked and undervalued in the 1990s,

small value mutual funds

soared at the beginning of the decade. While large growth mutual funds lost 13% in 2000, small value returned 19% for the year.

What lessons should you draw from the recent market performance? First, it pays to diversify. In the past, many financial advisers believed that investors could diversify by putting 60% of assets in the S&P 500 and 40% in investment-grade bonds. But that was not the ticket for success in the difficult decade that began in 2000. Instead, it was necessary to hold a broad range of assets.

The second key lesson is that the best returns went to investors who embraced unloved sectors. While technology floundered in the past decade, investors got double-digit returns from precious metals and energy, sectors that were shunned in the late 1990s.

Real estate mutual funds

, another category that had been unloved, returned 9.8% for the decade.

These days investors should underweight some of the hot performers and emphasize sectors that trailed for the decade. After returning 31% in 2009, the average real estate fund now has a sky-high price-to-earnings ratio of 31. That's a steep price at a time when commercial property markets remain deeply depressed.

Cautious investors may want to hold a

precious metals mutual fund

as an insurance policy against a collapse in the financial system. But keep in mind that the cost of the insurance is not cheap. The funds, which hold mainly mining stocks, returned 52% in 2009 and now have a P/E multiple of 29.

After the thumping they took in the past decade, blue chips no longer seem expensive, and investors should overweight them. Morningstar's large blend category, which includes S&P 500 index funds, commands a reasonable multiple of 14. Bargain hunters should note that the cheapest stock categories tracked by Morningstar are abroad. Foreign large blend funds have a P/E multiple of 12, while foreign small-mid value has a multiple of 11.

No matter which stocks you hold, consider diversifying by owning a wide selection of bonds. Here, too, you should be wary of the top performers from the past decade.

With investors seeking the safety of Treasuries,

long government bond mutual funds

returned 7.7% annually and ranked as the top-performing category among U.S. bond funds. Now government funds look risky. When interest rates rise, long government funds collapse. That has happened in recent months. More declines could be in store, if the Federal Reserve raises rates this year, as many economists expect.

High-yield mutual funds

ranked as one of the worst-performing bond sectors of the past decade, returning 4.7%. Junk bonds were thrashed during the turmoil of 2008. Now the funds yield 7.6%, an attractive payout. Just as important, high-yield bonds can help to diversify a portfolio because they sometimes rise when investment-grade bonds decline.

Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.