Lessons from the “lost decade”

Posted by on April 3, 2009 @ 8:56 am in investing

Here’s a table that codifies the pain of investing over the past decade. It compares the results of investing in several asset classes under two scenarios: A $10,000 lump-sum investment at the beginning of the decade, and a regular $1,000-a-year investment over ten years (in a 401(k) plan, for example).

The "lost decade"

The top-line results are not surprising. Bonds beat equities (of all types), whether you were investing a lump sum or using a dollar-cost-averaging approach. Two small surprises stand out. For the lump-sum investor, international and small-cap stocks outpaced large-cap stocks and actually made money. For the dollar-cost-averaging investor, a regular investment in international stocks (yes, international stocks!) handily beat U.S. large- and small-cap equities and made money. Small-cap stocks came $87 short of breaking even. (Note that none of these results include real-world fees and expenses or taxes, which would reduce them further.)

Another surprise is that values are lower across the board for the dollar-cost-averaging investor. Why? Think of this investor as making ten distinct investments with ten different holding periods: $1,000 invested for ten years, $1,000 for nine years, $1,000 for eight years, and so on. Many of these dollars were committed during peak years, and now those investments are under water.

What do we conclude from this exercise? That it’s a crapshoot to invest in equities?

Before drawing that particular conclusion, consider this: An investor in 1999 was buying into a picture-perfect U.S. economic outlook and a roaring stock market. Nothing, it seemed, could go wrong. An investor buying (or holding) stocks today is looking at the worst U.S. economic outlook since World War II—driven in part by a near-collapse of the banking system, last seen in the 1930s. Today, everything appears to be going wrong!

From my perspective, it doesn’t make much sense to base portfolio decisions—and the long-term case for investing—on such extremes. Bad ten-year periods can and do occur, but they are not the norm. There’s a danger in building a view of the future from a decade that began with near-mania and ended with near-disaster.

Investing is inevitably about how we think about the future. If you believe that economic conditions will deteriorate over the next ten years as they did in the past ten, then by all means—consider investing only in “safer” investments. (You should also have a strong view of how much worse the economy can actually get.)

But if you believe, as I do, that economic conditions are likely to improve over the coming decade, there’s still a strong case to be made for taking risk. That’s the real lesson of the “lost decade.”

* Historical investment results are based on the following indexes: for large-capitalization U.S. stocks, the Standard & Poor’s 500 Index; for small-capitalization U.S. stocks, the Russell Index through May 16, 2003, and the MSCI US Small Cap 1750 Index thereafter; for international stocks, a composite of the MSCI Europe Index, the MSCI Pacific Index, and the MSCI Emerging Markets Index; and for bonds, the Barclays U.S. Aggregate Bond Index. Calculations assume a beginning-of-period cash flow convention. The returns are on a gross basis and do not reflect the impact of fees or other expenses or taxes.

Notes:

• All investments are subject to risks. Investments in bonds are subject to interest rate, credit, and inflation risk.

• Prices of mid- and small-cap stocks often fluctuate more than those of large-company stocks. Foreign investing involves additional risks, including currency fluctuations and political uncertainty.

• Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

• The hypothetical example does not represent the return on any particular investment.

We invite your comments on this Vanguard Blog entry. Comments will be monitored and published at Vanguard’s discretion. Comments received prior to July 7, 2009 will not be published.

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