What actually happened in the U.S Lost Decade?

What happened during the "Lost Decade" in the U.S and is there anyway to avoid another?

Some might familiarize the "Lost Decade" with Japan's years of economic downturn in the 90's, where the term originated after years of serious economic stagnation. The term paints a picture of a 10 year span of time of wealth that was completely wiped out. The years following, the U.S dealt with its own "Lost Decade", starting with the dot-com bubble from 200-2002 and ending with the housing bubble in 2007-2008. These two recessions at the start and end of the decade meant that any market gains in between were essentially wiped out. The question is, have we actually learned anything?

How did the Lost Decade impact the economy?

The happenings of the “Lost Decade” are fading in our memory, yet for some, especially for those who experienced substantial losses, the unsettling feeling is easy to recall. The “Lost Decade” was one of the worst moments in the recent stock market history as we observe the performance of the popular indexes: S&P 500, Dow and Nasdaq.
 
It was definitely a very bad time to draw income from retirement portfolios, but unfortunately, this is what many investors were forced to do. Some were already retired and dependent on income from their investments, and some were forced to retire during the financial crisis.
 
Warren Buffet said, “What we learn from history is that people don’t learn from history”. We all know that in the future we will experience recessions, and probably not just one, but many. Recessions will occur and can’t be avoided. We can’t predict when, how long and how bad the next recession will be, but we know someday we’ll get there.
 
Since evidence and research indicated that getting out of the market on time, just before a recession happens is almost impossible, we can look at the investment strategies that may allow us to stay invested and not be as heavily impacted as the whole market- as it is represented by S&P500, Dow and Nasdaq.
 
While past performance is not a guarantee of future results, we may be able to get some clues and try to prove Warren Buffet wrong by learning from history.
 
First let’s examine the S&P500 returns during the 2000 to 2010 period. The compounded annualized rate of return from year 2000 to 2010 has been negative 0.9%. The rate is derived from the following annual returns and in dollars, assuming $1,000,000 investment, the portfolio value would look like the following:
(Investment management or trading cost are not included in the calculation, you can not invest directly in the index).

The S&P 500: Lost Decade 2000-2009

We can clearly see why the above period has been called a “Lost decade”, in this scenario we started with $1,000,000, by the end of 2000 we were down to $909,000 and after 10 years, the investment value is equal to $909,400. It is disappointing, to say the least- no gains for 10 years and a surely a flurry of emotions that the investor had to endure looking at the statements in the bad years.
 
But this is not the end of the story, a really sobering moment is when we review the same portfolio, assuming the investor had to make withdrawals during that time. We’ll take a conventional approach, which may not be always the best, but this subject will be discussed in another article, and assume 4.5% withdrawal in the first year and increase the withdrawal each year with inflation. To simplify, we’ll assume 3% inflation rate.

Taking income during the Lost Decade

The last row added is the amount withdrawn each year and the 2nd row shows the account value after adjustment for the change in the market and a withdrawal.

It is clear that the strategy is not sustainable. From $1,000,000 to $363,828 in 10 years. Not only has it experienced long periods of negative performance, but it looks even worse if the portfolio is used in the distribution phase as a source of income.
 
One important point is that a portfolio positioned for income should not be in 100% equities, such as the S&P500 or any other combination. We have this subject addressed in our “How much can you afford to withdraw in retirement?” article.
 
Here, our goal is to create a better investment experience for investors and attempt to avoid long periods of negative performance.

As we already know, a properly diversified portfolio based on the dimensions of expected returns should include not only the S&P500, but other asset classes as well. See "Dimensions of Higher Expected Returns" article.
 
As an example, we have a Balanced Strategy Equity portfolio, created by using funds from Dimensional (DFA). The portfolio tracks 11 different asset classes and is tilted to dimensions of higher expected returns, value and small companies. It also includes international and emerging markets with the same tilt.

The compounded annualized rate of return from year 2000 to 2010 has been 7.4% (S&P500 produced -0.9%). Annual returns and portfolio values are listed below as we did in the example with the S&P500 above.
(The portfolio is provided as a sample and not as a recommendation, trading or advisory fees are not included in the calculation)

The Balanced Strategy Equity Portfolio (DFA Funds)

The portfolio value has more than doubled during the “Lost decade” while the S&P500 was negative 0.9% over the same time frame.
 
In the next example, we will test how withdrawals impacted the portfolio, but it is important to note, we do not suggest a 100% equity portfolio to be used when withdrawals are needed. The following example is included to complete a fair comparison. It does not matter how well diversified the portfolio is, it will experience volatility, and as we noted in this example the declines can be close or more than 40%. The period of time we are reviewing here is just that, a ten-year period. The next recession is not going to be the same, remember “past performance is not a guarantee of future results”. We can only use the history as a guide to understand the relationship between different asset classes, and their expected premiums and risk.
 
An example of income withdrawals from the DFA portfolio:

A balanced strategy for taking withdrawals during recessions and bear markets

After 10 years, accounting for withdrawals, from $1,000,000 in initial investment value, the S&P500 portfolio finished at $363,828 and the DFA portfolio finished at $1,350,469. Close to a million dollar difference.
 
Conclusion: Different asset classes and countries are likely to perform in their own way at different times. Proper diversification is essential and as we look at the history, there are asset classes that have done better than the S&P500 over long periods of time.
 
In this particular example, the “lost decade” was not “lost” for the DFA portfolio.
 
Critics may call this example a data mining, as it is too short of a period to draw a meaningful conclusion and they would be correct. Our goal in this exercise to examine the worst ten years only, since as of this writing we have been in a bull market for more than ten years now, “bad times” may not be that far ahead. The Fama and French research referred to in other articles is based on more than 90 years of data which allows for an evidence-based conclusion.
 
As we review a much longer period of 46 years, beginning in 1973 and ending in 2018, we should have better data sampling. The same DFA Balanced Strategy 100% Equity model produced substantially better results when compared to the S&P500 index.

The ​DFA Equity strategy produced better results compared to the S&P 500 or as many may call it “The Market”. It is also important to understand that the results were achieved over a long period of time. There were and will be periods of time when the S&P 500 or any other asset class will produce better results over a shorter period of time than a balanced diversified strategy.
 
Reacting and changing the strategy based on the headlines is likely to diminish potentially better results.
 
What are the odds the portfolio tilt or dimensions of higher expected returns will do better?
Below is the historical performance of Premiums over Rolling Periods.

​US Markets
 
Value beat Growth
Overlapping Periods: July 1926 – December 2017
10-Year: 84% of the time
5-Year: 75% of the time
1-Year: 61% of the time
 
Small beat Large
10-Year: 72% of the time
5-Year: 64% of the time
1-Year: 57% of the time
 
High Profitability beat Low Profitability
Overlapping Periods: July 1963 – December 2017
10-Year: 100% of the time
5-Year: 89% of the time
1-Year: 67% of the time
 
Developed Markets
 
Value beat Growth
Overlapping Periods: January 1975 – December 2017
10-Year: 95% of the time
5-Year: 89% of the time
1-Year: 69% of the time
 
Small beat Large
Overlapping Periods: January 1970 – December 2017
10-Year: 87% of the time
5-Year: 82% of the time
1-Year: 65% of the time
 
High Profitability beat Low Profitability
Overlapping Periods: January 1990 – December 2017
10-Year: 100% of the time
5-Year: 87% of the time
1-Year: 79% of the time
 
Emerging Markets
 
Value beat Growth
Overlapping Periods: January 1989 – December 2017
10-Year: 86% of the time
5-Year: 84% of the time
1-Year: 50% of the time
 
Small beat Large
Overlapping Periods: January 1989 – December 2017
10-Year: 86% of the time
5-Year: 72% of the time
1-Year: 63% of the time
 
High Profitability beat Low Profitability
Overlapping Periods: July 1995 – December 2017
10-Year: 100% of the time
5-Year: 100% of the time
1-Year: 76% of the time
 
By constructing a portfolio to target dimensions of higher expected returns, we’re tilting the odds in your favor.
 
Please keep in mind, the 100% Equity Strategy discussed here is not appropriate for everyone. Each investor is unique, and each situation is different. Based on our experience, each portfolio should be designed individually, taking into consideration investor goals, time horizon, risk tolerance, risk capacity and many individual factors, constrains and preferences. This is one of the reasons we take time to draft an Investment Policy Statement for each client to lay a foundation and a framework for the portfolio management going forward. An Investment Policy Statement will address asset allocation, investment approach and discuss individual portfolio, including expectations and risks.

If you are interested in learning more about our strategic investment and withdrawal strategy, we would love to answer any questions you might have. You can contact us here, and a member from our team will get back with you as soon as possible.
 
If you are interested in seeing if the Dimensional approach and evidence-based investing could benefit your portfolio, we are offering a free test drive of our Financial and Retirement Planning Portal, offered at no cost and no obligation. You can click here to learn more, or schedule a complimentary phone call with us to discuss in person!