Don't Let A 'Lost Decade' Destroy Your Retirement

by: Eric @ SERVO

Summary

Historically, and most importantly today, a stock-oriented asset allocation is your best chance for retirement success.

Critics make the mistake of thinking the large-cap, growth-oriented S&P 500 Index is representative of all stocks and their frequent "lost decades" spell doom for all stock portfolios.

Adding large/small value stocks to the S&P 500 not only increased historical returns dramatically, but added meaningful diversification benefits that would have helped retirees avoid lost-decade disasters.

I've written several articles in the last month or two that are not exactly conventional from the standpoint of retirement-planning advice. "How Can You Not Love Equities?," "The Dumbest Things You Can Do With Your Retirement Dollars" and "The One Investment All Retirees Should Own" each had similar themes - for an individual or family who is about to retire or is already in retirement and who needs a rising income stream over several decades, putting most of your money in a diversified portfolio of stocks represents your best chance for success.

This point of view runs counter to convention for a few reasons. First, it seems hard to believe that stocks, which have considerable volatility and occasionally lose 30%, 40% and even 50% of their value, can be an appropriate investment for someone who needs regular ongoing income. Second, we know that stocks, despite significant long-term returns, endure long periods of minimal or even negative growth, which is problematic for retirees who don't always have the ability to wait for better long-term returns to show up.

It is this second point that frequently shows up in the comments section of these articles, and must be on the minds of the tens of thousands of others who have read them. And, guess what? I agree with you. There is a major flaw in the idea that you should have most or all of your retirement in stocks as we generally define them - the S&P 500 or S&P 500-like stocks.

Period

Inflation (NYSEARCA:CPI)

S&P 500 Index

US Large Value stocks

US Small Value stocks

1970-1979

+7.4%

+5.9%

+12.1%

+14.2%

1980-1989

+5.1%

+17.6%

+20.6%

+20.1%

1990-1999

+2.9%

+18.2%

+16.8%

+16.2%

2000-2009

+2.5%

-1.0%

+4.0%

+12.7%

2010-2015

+1.5%

+13.0%

+11.8%

+11.7%

Total Period

+4.1%

+10.3%

+13.1%

+15.2%

Click to enlarge

The table above looks at the annualized returns of the S&P 500 and inflation during every decade since 1970. From 2000-2009, the S&P 500 actually lost 1% per year while we experienced modest inflation of 2.5% annually. This painful period became known as the "Lost Decade." But was it an outlier? Looking back only 3 decades earlier, we see the answer is no. From 1970-1979, the S&P 500 logged modest positive annual gains of +5.9%. But inflation was higher than average, +7.4% per year and stocks wound up with a -1.5% per year real return.

Of course, 1980-1989, 1990-1999 and the decade that began in 2010 show different fortunes. The S&P 500 has returned +13% to +18% per year during these stretches. So a stock-heavy portfolio consisting of the popular S&P 500 (or its kissing cousin, the Total Stock Index, or even a basket of the individual stocks typically found in the S&P 500) sometimes works remarkably well and other times is a complete disaster.

It would appear then, that my advice to hold equity-oriented retirement portfolios is predicated on a fair amount of luck - that you just happen to retire during a period where we experience a bull market for blue chips.

Except that I don't have the same definition of "stocks" that you probably do. I believe in classic diversification, not just amongst US and non-US stocks, but also across large/small and growth/value companies. The S&P 500 fits nicely into my philosophy, but only as a small component of a more balanced "asset class" portfolio. I view the S&P 500 or Total Stock Indexes as effectively large-cap, growth-oriented strategies and pretty good ones at that. But I don't see them as nearly sufficient to represent an entire stock portfolio. The table above tells you why. It's not just that large/small value stocks have generated significantly higher returns, it's that they've done so at different times. The 1970s' lost decade wasn't so bad if you owned some large/small value stocks that produced +4.7% to +6.8% per year more than inflation (a 60/40 mix returned +5.8% more annually), nor was the 2000s, when large/small value produced +1.5% to +10.2% per year more than inflation (a 60/40 mix returned +5.1% per year more).

Raw returns are one thing, but when you see how they affect actual retirement plans, it makes my point that much more important. Consider two hypothetical retirees, Edward and Andrew. Both rode the 1990s bull market to what they believed would be a comfortable retirement with $1M each. They needed only $50k (5%) per year adjusted for inflation and hoped there would be plenty left when their retirement was over to leave behind an important legacy.

The first retiree, Edward, was overconcerned with his portfolio's expense ratios and opted for a low-cost index mix of the Vanguard S&P 500 fund (VFINX 53%), the Vanguard Total International fund (VGTSX 22%) and included a small amount (VBISX 25%) in the Vanguard Short-term bond index for liquidity. He knew this would have worked wonderfully in the 1980s and 1990s.

The second retiree, Andrew, knew what worked well in the 1980s and 1990s as well, but had also studied the previous decade of the 1970s and knew that the S&P 500 was not always a market leader. He opted for the same 75/25 stock and bond portfolio as Edward but employed an asset-class approach that included US and international large and small value stocks (DFVLX, DFSVX, DFIVX and DISVX) as well as the S&P 500 (and used global instead of US-only short-term bonds).

For two hypothetical retirees with the same goals, same starting value and general asset allocation (75/25 stocks to bonds) you'll probably be surprised to learn how different their results have been since the turn of the century.

Investor

April 2016 Ending Portfolio Value

Edward

$349,744

Andrew

$1,399,286

Click to enlarge

By 2016, the inflation-adjusted annual withdrawals had surpassed $70k for both of our hypothetical retirees. Unfortunately for Edward, the lost decade had destroyed his retirement. He has less than 5 years remaining of his current-year income remaining in his portfolio, and now faces the painful decision to either cut his spending by 70% or 80% to avoid running out of money, or go out in a blaze of glory by spending what little is left and face a drastically diminished retirement within just a few years.

Andrew is in exponentially better shape. 16 years after he retired, his portfolio had growth of about $400k, and the inflated annual spending amount still represented the same withdrawal rate - 5% - that he started with in 2000. And with probably at least half of his retirement now in the rearviewmirror, the odds he would ever face the prospects of running out of money are remote (even with no portfolio growth, $1.4M represents 20 years of $70k per year withdrawals - which would support a retirement spanning almost four decades!). That legacy he wanted to leave behind once his retirement ended seems a good bet to be much greater than even his starting retirement portfolio's value.

The fact is, whether you've recently retired or will soon, you have no way of knowing whether or not you're on the cusp of a 1970s/2000s-type market or a 1980s/1990s one. With the latter, you'll likely be successful simply by owning a growth-oriented stock portfolio; small/value diversification should help some, but it'll just be an icing on the cake. With the former, however, plunking everything into the S&P 500 could result in a disaster. In an era where the amount you hold in bonds (which hopefully isn't excessive) is not going to earn much and "return of principal" is about the best case scenario, the decision of not only how much you allocate to stocks but also what stocks you own has never been more important. Start with a portfolio that emphasizes equities, diversify them broadly, stick with your plan and you just might avoid seeing a lost decade destroy your retirement.

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Source of data (table 1): DFA Returns Web

US Large Value stocks = Dimensional US Large Value Index

US Small Value stocks = Dimensional US Small Value Index

Inflation = Consumer Price Index

Past performance is not a guarantee of future results. Index and mutual fund performance shown includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products or services.

Disclosure: I am/we are long DFLVX, DFSVX, DFIVX, DISVX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.