A topic that is commonly discussed these days in the personal finance community is something called, “The Lost Decade.” In fact, while I was recently reading several financial magazines, I found out that many would-be experts would have us believe that the past 10 years were completely useless for investors. Quite a bold statement if you ask me!
After reading these statements, I began to wonder, “What facts do the actual numbers dictate to us?” This analysis will be the topic of today’s post.
What Is The Lost Decade?
For those of you unfamiliar with the phrase, “The Lost Decade,” it basically is referring to the fact that during the past ten years, the stock market has fluctuated up and down, but has only gone up 0.48% overall from start to finish. This performance can be seen from the Google Finance screenshot of the S&P 500 index above.
Now, I’m definitely not going to argue that a 0.48% return spread over 10 years is good. Quite the opposite, actually. Earning a 0.48% return is ridiculous! If an investor was to just earn this return, it would be quite accurate to call the 10 year period, The Lost Decade. After all, you could have earned more by merely investing in an online bank savings account!
However, my disagreement with this phrase/name stems from my belief that it does not capture the actual way that the majority of individual investors save (or should save) for retirement.
How Do The Majority of People Save For Retirement?
OK, so if I’m not quite ready to jump to labeling the past decade as “The Lost Decade” because it doesn’t capture the way that most investors save money, just how do I believe people go about tackling the beast we know as “investing?”
In my opinion, when it comes to squirreling away the money that matters for retirement, most people invest using dollar cost averaging (or something similar). This strategy involves investing a specific amount of money (or specific % of your income) each month. By doing this, an investor can accumulate shares of the investment he or she specifies at varying price levels, with more shares being purchased during stock market declines and fewer shares being purchased at higher prices.
Because dollar cost averaging results in ownership of shares purchased at many different price levels, further analysis is required before we place a label on the past decade.
Dollar Cost Averaging Analysis of Two Portfolios
After several iterations of trying to decide on the most effective way to demonstrate this, I decided on two hypothetical portfolios – a basic portfolio and an expanded portfolio.
Both portfolios have the following shared characteristics:
- Examine the total return and investment risk (standard deviation) of a $10,000 initial and $500 monthly follow-on investments from June, 2001 to June, 2011.
- Employ an overall asset allocation of 25% fixed income investments and 75% equity investments.
- Assume monthly rebalancing to maintain these asset allocation targets.
- Naturally, passive investing is used because it has been show to outperform individual stock selection on a long-term basis.
- For simplicity, an analysis of the effect of trading commissions, taxes, expense ratios, and inflation is not included.
However, the two portfolios diverge in regards to the specific mix of investments used to achieve the 75%/25% overall asset allocation split.
The basic portfolio invests only in two assets – 1-year Treasury Bills (T-bills) for the fixed income portion of the portfolio and an S&P500 index fund for the equity piece.
The expanded portfolio uses the exact same index mutual fund asset class selection as I do currently, as shown in the list below. All investments are assumed to be Vanguard index mutual funds, except for the T-bills portion.
Note: All Vanguard mutual fund historical price data was downloaded from Yahoo Finance for the analysis.
This asset class mix/investing strategy was the result of multiple books about Modern Portfolio Theory, including A Random Walk Down Wall Street by Burt Malkiel, Stocks for the Long Run by Jeremy Siegel, and What Wall Street Doesn’t Want You to Know by Larry Swedroe.
1. % Cash (T-bills Target 5%)
2. % Non-Inflation Protected Bond Funds (Target 15%)
3. % TIPS Bonds – (Target 5%)
4. % International Equity (Target 11%)
5. % International Emerging Markets (Target 11%)
6. % Domestic Large Cap (Target 8%)
7. % Domestic Small Cap (Target 8%)
8. % Domestic Small Cap Value (Target 14%)
9. % Domestic Large Cap Value (Target 13%)
10.% REIT (Real Estate Investment Trust – Target 10%)
As you can see in the list above, instead of just having one equity or fixed income asset class (like T-bills or the S&P 500), there are MANY! In addition, we have also added both international and emerging market index funds in to the mix.
I hypothesized that since these different asset have a correlation that does not equal 1, the expanded portfolio would offer a higher return for a given level of risk, consistent with the Efficient Frontier hypothesis/phenomena.
“So, enough talk, Jacob, what did you find out as your results?!”
The complete results of my analysis can be reviewed and downloaded at the shared Google Docs spreadsheet below. Enjoy!
However, a summary of my findings can be found in the table below.
The results of the basic portfolio with the application of dollar cost averaging were somewhat disappointing, with a total return over the past ten years of only 12%. However, this is still definitely better than a 0.48% overall return! During the ten years, we saw that by using this investing strategy, your money would have grown to a current value of ~$79,000.
The results of the expanded portfolio were surprisingly much better. I guess I always have read that this asset allocation stuff works, but have never done this in-depth of an analysis to determine just HOW effective it is!
A total return of 55% was realized over the 10 years. While this is not the 10% yearly average return that the stock market has provided since the 1800′s, it is a 351% increase in return compared to the basic portfolio. Quite amazing! The ending value of the portfolio was almost $30,000 higher than the basic strategy.
It is important to realize that the expanded portfolio value standard deviation did increase by 50%, so it was not completely a free lunch. The increased standard deviation was most likely contributed by the small cap, small cap value, and emerging market funds, as these are generally regarded as higher risk investments.
Now that the dust has settled (or maybe a more accurate saying would be that the spreadsheet electrons have settled) from this analysis, let’s take a step back and see what sort of conclusions we can draw. Several of the key ones I could think of are listed below:
- Even though the past ten years were not the best for investors, I don’t think I would consider them to be “lost” and completely useless to our wealth building goals. However, I suppose this depends on your required rate of return.
- The application of periodic investments using dollar cost averaging can produce higher overall returns than just investing one lump sum because it enables you to purchase lower-priced shares.
- Passive investing works. I would recommend using it! :)
- The addition of different asset classes (small-cap, large cap, value, international, etc) to a portfolio is beneficial for returns and risk management. However, it isn’t absolutely necessary, unless you are someone who enjoys managing your own money (as I do). If you like to keep things simple, merely having 2 index mutual funds will most likely provide adequate exposure.
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