Tuesday, May 31, 2011

How many "lost decades"?

It is perhaps a reflection of the perceived self-importance of the financial industry -- it is the axis about which the world revolves -- that the term "lost decade" refers to any ten year period in which the stock market actually declines in value. An entire decade of history is deemed to have been lost. Fortunately, such events are exceedingly rare -- or so most people think.

Not quite. Economist Blake LeBaron finds that the likelihood of a lost decade -- as assessed by the historical data for U.S. markets -- is actually around 7%. That's the historical chance for the numerical or nominal value of a diversified portfolio of U.S. stocks to fall over a decade. Calculated in real terms -- adjusting for inflation -- makes the probability significantly higher, probably over 10%, not really an extremely unlikely event at all. The figure below (Figure 1 in LeBaron's paper) shows the calculated return over ten year windows over the past 200 years or so, and shows maybe six or so episodes in which the real return descends into negative figures.

Not an earth shaking result, perhaps, but a useful corrective to widespread belief that long term drops in the market are truly exceptional events. As LeBaron comments,
Lost decades are often treated as a kind of black swan event that is almost impossible. Results in this note show that while they are a tail event, they may not be as far out in the tail as the popular press would have us think.... A life long investor facing 6 decades of investments should consider a probability 0.35 of seeing at least one lost decade in their lifetime.

Blake pointed out to me in an email that the term "lost decade" of course has much wider meanings that what I've discussed here, arising for example in discussions of Japan from 1990 to 2000 (and maybe longer).