Portfolio Planning and the Lost Decade 18 comments
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Assessing the Lost Decade
The Wall Street Journal wrote an article back in March in which they noted that the S&P 500 had delivered essentially no return over the past nine years. They dubbed this period “The Lost Decade,” and the article has since received considerable attention in the wake of declining markets and waves of bad news for a range of sectors. The big thing that everyone seems to be debating is whether this is simply a normal part of the economic cycle or if “the wheels are coming off.” To put this decade-long period of low returns on the S&P 500 in historical perspective, I liked the graphical presentation by Bespoke Investment Group.
In this article, they look at rolling ten-year returns for the S&P 500. Their results show that the S&P 500 has most recently delivered a ten-year return comparable to the 1970’s, which was not a good decade for stocks. The historical rolling ten-year periods have exhibited an enormous range of outcomes, and we are currently in a down period. While there is plenty of grim news out there, I wanted to look at this performance in a larger context.
Let’s start by noting that the S&P 500 is a stock index that has its allocations to individual stocks determined by their market capitalizations. There are plenty of good reasons why investors might want to allocate even their large-cap domestic holdings in some other way. Before the meltdown in financials, about 20% of the S&P 500 was allocated to financial firms. The S&P 500 is one way to create an index of the performance of stocks, but it is not the only way. This said, many investors and portfolios managers use the S&P 500 as a benchmark, so we will forge ahead on that basis.
A Statistical Perspective
Instead of looking just at market history, let’s consider Monte Carlo simulations of long-term expected performance for the S&P 500. Quantext Portfolio Planner [QPP] is our portfolio management tool and its uses the Monte Carlo approach. To analyze the relative probabilities of long runs with zero or near-zero total return, I run QPP with all default settings and the standard initialization data of three years (through May 2008). QPP simulates a range of possible future outcomes via Monte Carlo simulation, and thereby allows me to estimate the probability of a decade-long period with zero returns (or worse).
To make this really concrete, let’s make a test case of a 40-year-old who is investing for retirement. QPP provides the following projections for his/her cumulative returns in about nine-year’s time and in about ten-year’s time, assuming investment in IVV or some other low-cost S&P 500 index fund:
100% of Funds Invested in S&P 500 (IVV)
What is most striking when you look at these results is that the possibility of cumulative returns around zero falls between the 5th percentile and 10th percentile---even over a ten-tear period. This means that there is between a 1-in-20 and 1-in-10 chance of having returns at or below zero for a holding period of ten years. This is remarkably consistent with the fact that we have seen six 10-year periods in the last hundred with returns as low as we have seen for the most recent ten-year period (see the Bespoke article linked above).
Theses results highlight the importance of using probabilistic models to plan for the future. The median outcome is for a cumulative return of 115% over the next decade, but there is a 1-in-20 chance of -9% cumulative returns. We experienced negative real returns for the S&P 500 over decade-long periods in the 1970’s and we are experiencing it again now.
The Power of Diversification
A major lesson to be drawn from this sort of analysis is why it is important to diversify effectively across asset classes. Let’s consider these same probability levels for a diversified portfolio. Rather than create a new portfolio, I will simply use one from a recent article.
I decided to use a portfolio of ETFs with 20% bonds (hence the fairly unimaginative name P20):
P20 Portfolio
This portfolio combines allocations to the S&P 500 (IVV) and Russell 2000 (IWM) with healthy allocations to REIT’s (ICF), utilities (IDU), commodities (DJP) and energy stocks (IGE). The bonds are allocated largely to TIPS (TIP). The astute reader will note that this portfolio ended up with zero allocation to emerging markets (EEM)—for details on why, read the article.
Invested in P20 Portfolio
QPP projects that this portfolio will generate considerably higher returns than the S&P 500, with less risk: these are the fruits of diversification. There is still an enormous range in the projected returns, but the bad outcomes (the 5th and 10th percentiles) have improved considerably.
Summary
So, let’s put the Lost Decade in perspective. The most recent decade has not been good for the S&P 500. These kinds of decade-long periods have happened before (most recently in the 1970’s). When viewed through QPP, we see that these periods are sufficiently likely that they must be planned for---anything with a 5-10% chance of occurring is worth keeping in mind. This risk can be managed through smarter asset allocation strategies. Investors who have been well-diversified relative to the S&P 500 have fared far better in this decade than those who over-emphasized the S&P 500---and this is likely to be the case in the long-term. This is why many pension funds and other institutional investors have been looking beyond major equity indices for a substantial portion of their assets.
Sadly, a substantial fraction of mutual fund managers are, in fact, ‘closet indexers’ and don’t stray far from this benchmark. This means that many investors have a significant probability of ending up with very low or even negative returns over decades to come. If we add the unfortunate tendency of retail investors to chase hot sectors, it is easy to see a major crisis in the making for current generations with self-directed retirement plans.
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This article has 18 comments:
If you look at the original article in which I constructed the P20 portfolio, you will see that some of the portfolios did have EEM in them. If often find that EEM can be excluded because of the high correlations between EEM and the S&P500 (73%), EEM and EAFE (86%), and IGE and EEM (77%). From a statistical standpoint, major equity indices plus energy / natural resources indices capture the portfolio benefits of EEM in many portfolios.
In down (and flat) markets, the wonders of diversification are always trotted out. Not that any of us, myself certainly included, can lay claim to the mantle of Warren Buffett, but he had this to say about diversification: Diversification serves as protection against ignorance. If you want to make sure that nothing bad happens to you relative to the market, you should own everything. There is nothing wrong with that. It’s a perfectly sound approach for somebody who doesn’t know how to analyze businesses."
Remember, the website is Seeking Alpha.
My portfolio for most of the decade was MO and RAI which threw off the dividends that enabled me to buy BUD BRK JNJ BNI WMT and others.My book explained the filters and formulas that helped that. Picking the right stocks and staying concentrated is paramount
The point of this article is simply that reasonable expectations for the equity risk premium (which are lower than what we have experienced over recent decades, all in) are consistent with "lost decades" that are not too infrequent in the S&P500. The vitriolic response is wierd--this is fairly basic stats. Now, what is not so basic is the fact that spreading assets in a smarter way that cap weighting makes lots of sense and helps a great deal.
A number of critics seem not to understand the subtlety of what diversification means. It is not buying everything. My analysis of Berkshire's top holdings--a very concentrated portfolio--shows that the portfolios is actually very well diversified. Diversification is a measurable thing and you can have a concentrated portfolio that is also diversified. Buffett's quote is that WIDE diversification is protection against ignorance--this is a different thing entirely. The very fact that some Seeking Alpha readers find this controversial is argument enough for this kind of article.
Also, as far as the suggestion that QPP is a proprietary model that noone can see. To the contrary, QPP is extremely well documented, tested, and used by a wide cadre of investors.
Concentration and diversification are not contradictory terms...
Berkshire, or more specifically Buffett, doesn't look at risk premiums or benchmarks. Nor, I suspect, does Buffett care about diversification as it relates to returns during any time period. He simply seeks to buy good companies at reasonable prices. The reasonable price approach addresses the risk you are trying to reduce via diversification because any index/sector approach is not a business oriented approach to investing. From a business perspective, there is no inherent margin of safety in buying an index or sector fund. It is comparing apples to oranges. Whatever the measure of diversification within Berkshire's portfolio turns out to be, Buffett would likely consider the measure a curiosity at best.
CM in MA: Useful comments and I agree with points (1)-(4)--if investors could grasp these points, they would be far better off. We see in investor behavior (like performance chasing) that maony (if not most) investors don't understand these themes.
As far as comparing P20 to an equal-weighted portfolio of these assets--that is an interesting idea but may not be a great benchmark--depends on the risk, etc. Interesting idea, though.
I like your points on Buffett, too. The very high diversification benefits we find when we analyze Berkshire is fascinating. I can't explain this apparent paradox in his stated style and the fact that his portfolio looks like a textbook application of portfolio theory to me.
On a related topic, are you familiar with the government's Thrift Savings Plan? www.tsp.gov The reason I ask is that it is potentially a giant laboratory to study investor behavior vis-a-vis asset allocation decisions and results. As of Nov 2007, there were 3.8 million participants with $231.5 billion in assets. The TSP provides three asset class choices: equities (large-cap, small/mid cap, international), bonds, cash. There are some recently introduced lifecycle funds consisting of these choices. Awhile back, there was some discussion of including other asset classes, but that has not happened yet. For all intent and purposes, reallocation is cost-free, so that removes a factor from the decision process. It is interesting that limits were recently established for interfund transfers--folks were rebalancing/reallocati... too frequently and driving up plan costs for other participants. So, even with just five choices, it would seem there were some people attempting to time the swings in the markets rather than using some basic asset allocation to smooth the long-term ride. Anyway, I couldn't say whether the government has ever studied the results plan participants have achieved, or whether they'd even be interested in doing so. However, it strikes me as a well-controlled experiment in investor behavior.
The kind of study you are referring to has been done by DALBAR and is repeated every year (Google the term QAIB DALBAR):
www.thorntonwealth.com...
The statistics show that retail investors do chase performance and that this exacts an enormous cost. This is also seen in Morningstar's investor return stats. As I pointed out in some recent articles, the very first things for retail investors to do are (1) invest in a well-diversified low-cost portfolio, (2) avoid chasing performance.
The DALBAR studies are shocking...and they find the same stuff every year.
BTW, I was in the TSP when I was at NASA....
I was in the TSP while in the military. I think it is a great program. Keeps things simple. Many 401k/403b plans could (and do) do worse than use the TSP as a model.