My Biggest Fear

August 29, 2023

3:43 PM PDT

Olympia, WA

If you have talked to us lately or listened to any of our webinars, you’ll know that we have largely been talking about the likelihood of whether we’re going into a recession or not. This matters because if you’re a stock investor, recessions are painful. On average, the stock market declines about -29% from peak to trough during a recession. That’s a big loss. If you started with $1 million, you’d be down to $710k at the bottom. This would most certainly be a rough experience, but if you put things into perspective, it’s not as big of a deal as it seems. There are always going to be recessions. They’re an unavoidable part of the economy and markets, but realistically, most of the time they’re relatively short-term in nature. In the past, if an investor had taken a long-term approach, they would have always made their money back and more following a recession. Sometimes, they would have recovered in a few months, but other times it would have taken several years. A looming recession remains one of my fears, but because we have always recovered from recessions in the past, it is not my biggest fear.

What I am really fearful about is the possibility of another lost decade. A lost decade is a period of 10 years or more where stocks have returned close to 0% per year. We have had these many times in the past, such as from 1968 (when the Dow first hit 1,000) to 1982 (when the Dow finally continued above 1,000). Stock prices posted no gains during this period, but fortunately investors could rely on dividends to generate some return. Just recently, we experienced this in the 2000-2010 decade, where if you had invested in stocks in 2000, you would have had less money than what you started with a full 10 years later. During the 2000-2010 decade, even dividends were not enough to give investors a return during this period.

Recessions don’t typically disrupt a lot of financial goals because they tend to be short-term in nature. A recession can certainly alter the timing of achieving a goal, but if an investor were to remain invested, they would eventually achieve their goal, just at a later date than originally planned. Lost decades are different. If an investor is unfortunate enough to have their financial goals coincide several years into or toward the end of a lost decade, it could mean that the goal is not achievable at all. Some of the bigger names in the investment world, such as Stan Druckenmiller, have made calls recently that they think we are heading into a lost decade. This possibility brings this fear to the forefront when managing investment portfolios.

Fortunately, there is a solution to my fear of a potential lost decade. It’s a solution that we all know about – diversification. Diversification is one of the most repeated concepts in finance, but in my view, most people aren’t doing it correctly. Many people view the S&P 500, the Dow, or the Nasdaq as a diversified index that will cover all their diversification needs. Each index holds a number of different company stocks across a variety of industries, so they each seem diversified. However, if we look back, we can clearly see that this style of diversification has failed many times in the past. When stocks do poorly, they tend to all do poorly to varying degrees. While you may hold many different kinds of stocks in one of these indexes, you are ultimately all in US stocks. This is not a good place to be when US stocks have a prolonged period of poor performance. I believe true diversification encompasses three factors: 1) a global approach, 2) defensive capabilities, and 3) exposure to assets and strategies that aren’t correlated to the direction of the economy.

Here's what that would have looked like during the 2000-2010 lost decade. If you were to have taken a global approach by investing in non-US stocks along with US stocks, you would have experienced a positive return. During this period, non-US stocks gave investors the diversification they were looking for vs US stocks (Non-US stocks in blue, US stocks in green):

Incorporating an investment with defensive capabilities during this period would have been a big benefit. There are a lot of ways to go about this, but bonds are the easiest and one of the most consistent defensive assets to utilize. Bonds were consistently positive throughout the whole decade while US stocks struggled (Bonds in blue, US stocks in green):

Additional uncorrelated investments that don’t care if we’re in a boom or a bust help tremendously during these periods. There are a lot of investments that hit the mark here, but I tend to like precious metals and trend-following managed futures strategies the most as they also tend to have strong performance in harsher environments (Gold in blue, Trend-following managed futures in orange, US stocks in green):

If we tie all of these things into a simple diversified portfolio construction where we have 35% in US stocks, 15% in non-US stocks, 25% in bonds, 10% in gold, and 15% in trend-following managed futures, we can see that we would have done much better during the lost decade than if we had just been all in a “diversified” portfolio of US stocks (Diversified portfolio in green, US stocks in blue):

One thing to notice is that this diversified allocation was not immune to market crashes. While it did outperform pure US stocks during market crashes, the main goal is to avoid a lost decade, not necessarily to make a consistent return every year.

If we extend this chart through the first half of this year, 2023, we can see that US stocks would have eventually caught up and outperformed after the 20-year mark, but an investor would have had to suffer through a lost decade. The diversified portfolio, on the other hand, did not have to suffer through any lost decades and barely underperformed over the whole period (Diversified portfolio in green, US stocks in blue):

Ultimately, there are always trade-offs. If US stocks continue the surge they have been on for the last 10 years, a diversified portfolio would underperform. However, if we see some semblance of a lost decade going forward or any other outcomes that could cause a pure US stock portfolio to underperform, a diversified approach would be the winner. Investors now have to make the decision of whether they want to continue chasing last decade's winner or whether the possibility of a lost decade is enough to consider diversifying. I showed just one example of how to diversify using somewhat arbitrary allocation weightings, but there are many ways you could go about it while still achieving a good outcome.

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