Was It Really A Lost Decade?

January 25, 2010

What long-term lessons can be gleaned from the last decade for how to best allocate assets and structure equity indexes?


Overconfidence gets human beings into big trouble. Fueled by new developments in science and ready access to current and past knowledge and theory, old cautionary rules are thrown out the window at considerable peril. The past century spans two prominent examples of disasters from learnedness-induced overconfidence. The sinking of the Titanic in 1912—the ultimate shipping disaster—was the direct result of the luxury liner, emboldened by its “unsinkable” engineering, plowing through the twin dangers of poor visibility and icebergs at top speed.

Almost 100 years later, an unshakeable faith in the equity risk premium—reinforced by vast data supporting a 10% annual long-term return—caused the $8 trillion U.S. pension supertanker to charge ahead with massive equity allocations into a decade that did not reward equity investors, despite the warning signs of high valuation multiples, 1% dividend yields, and skewed indexes.[1] The sinking of the Titanic was tragic for hundreds of families; the equity market underperformance of the last decade has impacted millions of investors.

The “naughts” were the worst decade ever for
equity investors, even after an astounding rebound in the past 10 months of 2009, during which the S&P 500 Index surged 55%.[2] Yes, worse than the previous two low points: the 1850s and the Depression-riddled 1930s. The result was the “Lost Decade” where the S&P 500 compounded at –1.0% per annum—3.6% below the rate of inflation! The 1850s and 1930s produced +0.5% and –0.1%, respectively. This cumulative loss dragged the total return of the traditional balanced portfolio of 60%
equities (as measured by the S&P 500) and 40% bonds (as measured by the BarCap Aggregate Index) to 2.3%, trailing inflation by 30 bps per annum.

The picture grows far worse when we incorporate typical pension liabilities and 401(k) target returns. Pension liabilities, as measured by the Ryan Labs Liability Index, advanced at an annualized clip of 8.5% per annum. So while the cumulative gain for the 60/40 portfolio was about 25% (less costs), typical pension liabilities advanced over 125%, nearly halving pension funding ratios. The statistics are far worse for 401(k) investors, very few of whom are even vaguely aware of the liability side (their future spending needs).

Most 401(k) educational materials and retirement planning models use too high a return assumption (often 8%) in calculations to estimate how much money to set aside, and tacitly encourage a reliance on growth stocks. Most 401(k) participants did not achieve these overly optimistic returns; in fact, they were unlikely to even achieve the returns for a simple 60/40 passive return because of the higher relative costs of mutual funds, as well as a relentless tendency to chase past winners, reinforced by human resource departments which add the recently-best-performing products to the 401(k) fund roster. The concept of rebalancing—building on the idea that past is not prologue—is rarely followed in the retail community.[3]

In this issue we study this abysmal stretch of portfolio performance, both to glean long-term lessons for how we allocate assets and structure equity indexes and to consider whether the “naughts” might lay a foundation for a splendid decade ahead.



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