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.
- I would like to welcome the first Vancouver-based firm to my Find an Advisor directory. Macdonald, Shymko and Company pioneered the concept of fee-only financial planning 30 years ago. Their team can help index investors set up passive portfolio with ETFs and Dimensional Fund Advisors mutual funds, and they also offer planning services to clients who manage their own portfolios.
- A huge thank you to readers who responded to the charitable initiative of Justin Bender and PWL Capital in Toronto. About half a dozen DIY investors contacted Justin to get advice in exchange for a donation to the Centre for Addiction and Mental Health (CAMH). Thanks to you, Justin has raised close to $10,000 for this worthy cause. Nice work, everyone!