Finding The Lost Decade – A Case For Diversification

As a visual person, I like charts.  I also love reading about history, and one of my favorite things is maps with colors expanding as empires rise and fall. So, when Morningstar came out with the article of What Prior Markets Can Teach Us About Navigating the Current One with a gigantic graphic of historical market downturns, I was in heaven. Not as much as Julius Caesar’s invasion of Gaul, but close.

A close up of a map

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The growth of the capital markets is impressive; seeing their ability to grow wealth can’t help but make one optimistic about the potential. Being in the industry for over twenty years, the chart was not new, but to see one going that far back and with so much detail was impressive. And as with most things Morningstar, the color commentary around it was very well done.

Much like my interest in history, I like to know the details behind the outcomes. And in this case, there was something else nagging at me. I knew of the “Lost Decade”, but as someone who has put together portfolios for years, the lost decade seemed worse than it had to be. So, I pulled out my Kwanti portfolio analysis software and dug deeper.

The Morningstar chart was looking at the US Market, and my logical guess was the S&P 500, or some other US Large Company index. The S&P 500 is most often used as the main indicator of the “US Market”. Morningstar also uses “real” returns, which means taking into account inflation.

It did not take long to see where the lost decade came from:

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Morningstar’s Lost Decade was from August 2000 to May 2013 (actually almost 13 years – but decade sounds better). The above chart is from the middle of each month in question and is based on a total return, meaning dividends are taken into account, as they should be. The purple line is the Consumer Price Index, a common measure of inflation. The green line is a popular ETF (Exchange Traded Fund) that mirrors the S&P 500, ticker symbol SPY.

Now it doesn’t match exactly, and a lot depends on the exact start date and when, and if, dividends are reinvested (for our chart, they are), but you get the idea of where the lost decade comes from. The 2.35% annualized inflation rate comes close to matching the total annualized return of SPY of 2.73%. Basically, the S&P 500 was flat for the 13-year period based on purchasing power (inflation subtracted).

As someone who is a big believer in diversification, as I read the article I asked myself (I actually asked my spoodle Pebbles – with COVID-19 forcing me to work from home, I bounce ideas off her all the time): what if we added in other asset classes? What did small companies, mid-sized companies, emerging markets, and international do? The S&P 500 is only 500 companies from one country. The below chart sheds some light on the wanderlust decade.

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I have added the orange line, which is a common emerging market index, and the blue line is a common small company index. As you can see, the decade was not so lost for those two asset classes. What if we mix those asset classes with a few others with the S&P 500? And make a more diversified portfolio:

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The above green line is a total return portfolio using ETFs that replicate common indexes with an allocation of:

  • 40% S&P 500 (SPY – US Large Company)
  • 27% International (EFA – Developed Non-US Companies)
  • 16% Mid-sized US companies (VO)
  • 9% Small US companies (IWM)
  • 8% Emerging Markets (EEM)

As you can see, a diversified portfolio made the 13 years far from lost. It was actually productive, returning an annualized return of 4.64% vs. inflation of 2.35%. You can’t call it booming, but you certainly can’t call it lost. A $100 invested would have returned $178 before inflation and almost $135 after inflation.

During a bear market, like we have now with COVID-19, it is easy to bash “the market”. But as my Kwanti-based analysis shows, diversification makes the possibility of a “lost” decade less likely. The decade might meander a little, like a middle-aged man refusing to ask directions (before GPS), but the probability of getting a return above inflation is good.

And let’s not forget, retirement is not saved for in just 13 years. If you were buying into (dollar-cost averaging) the market during the lost years, you would have benefited greatly on the other side.

Our fear can reinforce misguided beliefs. Bear markets can benefit those that don’t fear but take advantage of the fear with knowledge. Knowledge is power.

Stay safe all, and next month we will continue with our Lost Decade conversation and look at what housing did during the same 13 years. We will also give you a FYI on a trick that insurance companies use to make the equity markets look worse than they really are.

During this time of stress, try to cultivate beauty every day.