Economics: How often do we “lose” decades?

According to actual history, much more often than most economists think

Research in economics has a notoriously slow turn around. People write papers and submit them for review, the back and forth haggling with referees goes on for a few years, and then, with luck, the paper finally gets accepted and comes out, possibly long after the topical importance of the subject matter has passed. That’s not the case, I think, with this paper, which I first saw as a “working paper” a couple years ago. It somehow slipped past me and made it “officially” into print late last year in the Journal of Financial Perspectives. And it’s still timely, as the global economy continues to sputter in the wake of the financial crisis that started 6-7 years ago.

The question the paper asks is — how unusual is it for an economy to actually “lose a decade?” To people in economics and finance, this refers to any ten year period in which the stock market actually declines in value. An entire decade of history is deemed, in this narrow way, to have been “lost,” even if we perhaps cured cancer during those years and made contact with friendly, intelligent life elsewhere in the Universe. (Well, this is economics.) Apparently, the accepted wisdom is that lost decades of this kind are exceptional episodes that only rarely interrupt normal steady economic growth and progress. As it turns out — not true.

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%, i.e. about 1 in 14. That's the historical chance for the numerical or nominal value of a diversified portfolio of U.S. stocks to fall over a decade. Doing the calculation in real terms -- that is, adjusting for inflation -- makes the probability significantly higher, more like 12%, so not really an extremely unlikely event at all. The figure below (Figure 1 in LeBaron's paper) shows the calculated return (nominal in yellow, real in dashed) 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 are almost impossible. Results in this paper 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. Allowing the data to speak directly in an independent bootstrap, with two centuries of return
time series, the estimate of a portfolio loss over a decade is about 7%. For the investor concerned with real returns the results are more depressing, with decade loss probabilities of 12%. …

The simple message here is that stock markets are volatile. Even in the long-run volatility is still important. These results emphasize that 10-year periods where
an equity portfolio loses value in either real or nominal terms should be an event on which investors put some weight when making their investment decisions.

Over the past 7 years, most stock markets have recovered to their pre-crisis levels. On the other hand, the past decade might well count as a lost decade if measured by a variety of other numbers, such as wages, overall economic output, etc. There’s no one right way to look at such things. LeBaron’s point is simply that such events are not the rare anomalies many people take them to be; they recur repeatedly through history.

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