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.
