The Timeless Harmony of a Balanced Portfolio

Deciding on the right asset allocation can cause investors a lot of grief—far too much, in fact, since there is no such thing as a perfect mix of stocks and bonds.

In his excellent book Your Money and Your Brain, Jason Zweig reveals that even Nobel laureates are not immune. Zweig tells the story of Harry Markowitz, the creator of Modern Portfolio Theory, who struggled to put his own idea into practice. “I should have computed the historical covariances of the asset classes and drawn an efficient frontier,” Markowitz once said. “But I visualized my grief if the stock market went way up and I wasn’t in it—or if it went way down and I was completely in it. So I split my contributions 50/50 between stocks and bonds.”

There’s something elegantly simple about a 50/50 portfolio. Indeed, when finance writer Scott Burns created the original Couch Potato portfolio way back in 1991, that’s what he recommended: half your money in a bond index fund, and a half in an equity fund.

Of course, investors often equate simplicity with a lack of sophistication. In the last couple of decades, asset allocation experts have strived to create more efficient portfolios designed to squeeze out every last basis point without adding additional risk. And yet, as recent white paper from Vanguard shows, that simple 50/50 portfolio would have served investors extremely well—not just over the last 20 years, but during nine tumultuous decades.

In good times and bad

The Vanguard paper, called Recessions and Balanced Portfolio Returns, looks at the hypothetical returns of a blend of 50% high-quality US bonds and 50% US stocks, going all the way back to 1926. It shouldn’t be surprising that the overall performance would have been excellent: the average nominal return was 8.3%. What was far more interesting was that the real returns—that is, the nominal returns minus inflation—were essentially the same during recessions and periods of prosperity.

The authors classified every period since 1926 as either a recession or expansion, based on the criteria used by the National Bureau of Economic Research. During recessions, the average annual return of the 50/50 portfolio was 7.75%, versus 9.90% during expansions. However, once you adjust for inflation, the real returns were 5.26% and 5.59%, respectively. The small difference is statistically insignificant.

There are a couple observations that explain this result. The first is that inflation tends to be higher during periods of expansion and lower during recessions. But more interesting is the relationship between the two asset classes in the 50/50 portfolio: “First, when a recession is imminent, there is a tendency for bonds to outperform stocks during the initial period of economic weakness (a ‘flight-to-safety’ effect). Second … stock prices tend to decline before a recession officially begins and to rise before it officially ends (a ‘leading indicator’ effect).”

The Vanguard paper is quick to point out that no one is guaranteeing 5% real returns from a balanced portfolio going forward. But there is good reason to believe that the interaction between high-quality bonds and stocks will continue: it is, after all, the very heart of portfolio diversification. Like the yin and yang, stocks and bonds are not opposing forces, but “complementary opposites.”

Quicken giveaway and more

  • Intuit Canada, makers of Quicken money management software, have offered to give away a copy of Quicken Home & Business 2012 to one lucky reader. This program, which retails for $110, allows you to track your cash flow and monitor your investments. To enter the draw, Tweet this post (include @cdncouchpotato so I can track you) or leave a comment below. Contest ends at midnight on Sunday, December 18, and I will announce the winner on Monday.

55 Responses to The Timeless Harmony of a Balanced Portfolio

  1. Braden December 17, 2011 at 3:28 pm #

    A question for the couch potato. After reading this months Moneysense mag, I was reading the best stocks in Canada article and how much money I would have made over the last number of years if I invested in their picks each year. Does the couch potato strategy allow for some investing in individual stocks, or is it “banned”? Do you personally invest in some stocks as well as ETF’s? Should one reserve the stock investments for “play money”? Thank you

  2. Maxwell C. December 17, 2011 at 5:33 pm #

    @Braden: Most people advocating a couch potato strategy suggest setting aside a small portion (5-10%) of one’s portfolio as “play-money” for screwing around and enjoying the gambles of the markets. This is a great idea as it can satisfy one’s trading urges while still keeping one disciplined enough to maintain the great bulk of one’s wealth on the indexed strategy.

    A lot of investing is psychological and a great strategy to which one doesn’t stick quickly ceases to be a great strategy. There are tons of people who read this blog, yet aren’t fully indexed. I’m not one of them, but I see whence they’re coming. Day-trading can be a LOT of fun, but doing it with a fixed percentage of one’s wealth keeps it at bay as an at-times profitable hobby (where it probably should be for the long term ;-).

    @Dan: Thanks to your excellent site and the information that it provides, I have educated my parents (who are in their 50s, still working full-time) regarding the couch-potato strategy. They were pretty pissed off to learn that their TD Waterhouse advisor had put almost all of their wealth into a managed fund that charged a 2.48% MER (and delivered pathetic returns last year…the bank made several times more than they did *on their money*). This made them a bit angry as my mom is the kind of person who won’t buy ANYTHING unless she knows all the details regarding any deferred charges and whether or not it can be returned in the case of material items.

    This week they will be switching everything over to self-managed TD Waterhouse RRSP accounts and going with a fully-indexed strategy using TD’s e-series funds for simplicity, and they are interested in learning more about this strategy. Thank you for the millionth time for maintaining this blog. I look forward to the information herein increasing any inheritance I might get down the road! 😉

    Speaking of the e-series…in a TD Waterhouse account, one can just buy them like any other security as one theoretically understands the risks involved and knows what one is doing, right? Unlike with a TD Canada Trust account wherein one must send in the form and convert the account over.

  3. Canadian Couch Potato December 17, 2011 at 5:38 pm #

    @Dale: To your question, “I wonder if it’s possible to run the asset mixes through a screener to discover the general asset mix with the lowest volatility possible?” It’s not possible to do this precisely (except in hindsight), but actually you are right on in terms of the best estimate.

    Markowitz’s original paper on MPT used two different stocks, one highly volatile and the other much more stable. He found that the optimal balance was about 80-20: in other words, allocating 20% to the high-volatility stock gave a higher average return and lower variability than the low-volatility stock on its own. Which is a very surprising result—thus the Nobel Prize.

    In terms of a stock bond mix, the same is likely true: a mix of 80% bonds and 20% stocks is likely to not only deliver higher returns than a 100% bond portfolio, but also lower volatility. For this reason, even very conservative investors should think carefully about avoiding the stock market completely.

  4. Canadian Couch Potato December 17, 2011 at 5:53 pm #

    @Braden: As Maxwell points out, buying individual stocks is not part of Couch Potato strategy, but no one is “banned.” 🙂 Personally, I don’t own any individual stocks and have zero interest in going down that road. But many investors do seem to like using a mix of strategies. In strictly mathematical terms, I expect that their stock picks will not add to their returns. But if indulging themselves with 5% or 10% of their portfolio discourages them from touching their serious money, then I think it’s a great idea.

    @Maxwell: Glad you and your parents have found the blog helpful. To answer your question about TD Waterhouse, yes, you should be able to buy the e-Series funds without having to go through the questionnaire and other requirements that are required for TD Mutual Fund accounts:
    http://canadiancouchpotato.com/2010/08/20/td-responds-to-e-series-concerns/

  5. Ritch December 18, 2011 at 3:10 am #

    The hypothetical 50% Stock and 50% Bond portfolio in the Vanguard study was rebalanced each month.

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