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 striven 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.”
Please enter me in the Quicken Draw. An thanks for all your great posts.
Enter me please!
I’ve always wanted to try Quicken, count me in for the draw!
it would be great to win the software, it would certainly be an improvement for what I currently don’t use, an outdated Money program. I got your Moneysense guide a little while ago. Great ideas!
This is an insightful post, thank you. I was wondering what the rebalancing frequency might have been in the study, quarterly, semi-annually, for example?
The 50/50 portfolio is making more and more sense. One thought I’m tickering with is for a growth or aggressive growth investor, keep 50/50 but within each asset class make suitable adjustments. For example, high yield BRIC corporate bonds which are certainly not for everyone, but aggressive within the bond weighting. Fixed income is steady trending insurance for a portfolio. With a lot of global uncertainty, a split might be the best option. Here is a post that complements your posting
http://moneyland.time.com/2011/11/29/how-to-earn-5-no-matter-what-the-economy-looks-like/?iid=pf-main-mostpop1
Sticking to any allocation you’re comfortable with is always the key.
In for the Quicken draw!
I like the fact that your site promotes balance in many ways. This includes lifestyle and charitable giving.
In for the draw Quicken Home & Business 2012
Good news about the Vancouver based fee-only firm. Hope to win the copy of Quicken!
Good post, as always. Please enter me in the Quicken draw. Thanks.
50, 50 sounds good to me right now. I’m underweight in the bond category but feel that it’s currently to expensive to bring up to balance. I’ve been buying whatever has been dropping which has been equities. I still question if perhaps I should buy more bonds as there is not sure answer to where things are going? Any suggestions? Also, I sure could use quicken so pls add me to the list:)
I’d be interested in seeing a detailed comparison between a 50/50 portfolio and a 40/60 portfolio, which is the more common default that one sees (for example the model portfolios on this site). From Vanguard’s conclusions, it appears that a 40/60 portfolio might have a slight larger difference in performance between recession and expansion, but I suspect that the average long-term growth is still better for a 40/60 portfolio.
Please enter me in the draw, Quicken is on my Christmas wishlist this year.
Nice post Dan, and your book (the Perfect Porfolio) makes a nice gift. Please enter me in the draw for the Quicken software.
Another great post. Please enter me in the Quicken draw!
Hi Dan, I like CAMH as a group as well. Probably one of my top charities as well.
Please enter me for the Quicken draw.
Thanks a bunch.
Please enter me in the draw.
I was wondering if you saw this article in the Globe and what your thoughts were about it.
http://www.theglobeandmail.com/globe-investor/investment-ideas/dan-hallett/mutual-fund-critics-missing-the-big-picture/article2272005/
Nice article. I’ll check the Vanguard link as well. Please enter me for the draw.
I like your title: “Timeless harmony of a balanced portfolio” as well as
“that simple 50/50 portfolio would have served investors extremely well—not just over the last 20 years, but during nine tumultuous decades.” The obvious conclusion is to get a timeless balanced simple 50/50 port. and leave it alone! I heard today that 70 is the new 60 etc. so why change one’s asset allocation with age? Dan, you’re a youngster now but are you going to change your allocation as you enter your 5th. and 6th. decade?
I’ve been following your blog since February, and our family has put about $100,000 into a balanced portfolio. What I need help with now, is transferring our RRSPs and RESPs from mutual funds into our do-it-yourself accounts. Can I open a second RESP account for each of my children, or do I need to transfer out of the mutual funds (we own several Fidelity products) in order to add money into index funds on my own?
Please include my name in the draw!
Karla
Many thanks to everyone who commented, and good luck in the Quicken draw.
@George: I believe the study assumed annual rebalancing only. Not sure how more frequent rebalancing would have changed the results.
@Chad: I did see that Time article, and I have to say, the headline is really misleading. It is totally incorrect to say that a 50-50 portfolio “will produce 5% annual returns like clockwork.” That is not what the study showed at all. No portfolio produces any absolute returns like clockwork.
@Phil: Re your comment, “I still question if perhaps I should buy more bonds as there is not sure answer to where things are going,” unfortunately no one knows where any asset class is going. That is the beauty of the simple balanced portfolio: it doesn’t need to guess.
@Echo: I think it’s almost certain that a portfolio of 60% equities would show larger differences between recession and expansion, and historically it would have provided higher overall returns. The effect that Vanguard is highlighting really only works with an even split.
@James: I always enjoy Dan Hallet’s perspective, and I’ve learned a lot from him. I tend to agree that the mutual fund debate in Canada has a tendency to miss some subtleties. It’s not just about MERs, and it’s not about structure (mutual funds v. ETFs). There are bigger issues regarding the way advisors are compensated, what value they can really add, etc.
@Jon Evan: I do expect my asset allocation to get more conservative, yes. I am 70% equities now and probably will be for a while, but I expect to gradually move toward 50-50 during the next 20 years. I am quite comfortable with volatility now, but once my portfolio grows and more dollars are stake, I may feel differently!
@Karla: The short answer to your question is, yes, you can open more than one RESP account for each child (just as you can open more than one RRSP for yourself). However, the contribution limits and grant amounts stay the same. Probably best to stop contributing to your current RESPs and RRSPs add all future contributions to the new index fund accounts. Then you can wind down the older accounts slowly and eventually transfer those assets into the new accounts.
I think an interesting question (for devotees of Modern Portfolio Theory) is whether cap-weighted equities without some kind of tilt are even on the efficient frontier any longer, given their relative performance and volatility over the last 30 years compared to other asset classes.
I’d love to be entered into the Quicken draw. I’m interested if they’ve improved their support for multi-currency TFSAs this year. Last year it was pretty buggy.
I really need to add some bonds to my portfolio… Very interesting post, as usual :-)
I don’t know too much about investing, but the 50/50 portfolio sounds simple and elegant enough to get me started. =)
Please enter me in the draw for Quicken!
Sticking to any allocation you’re comfortable with is always the key.
In for the Quicken draw!
Thansk Dan for the good blog. I would really put to good use this Quicken Home and Business 2012.
Agreed about the specified rate of return being misleading, but the concept has some merit.
I am one of the lucky ones accepted by Justin Bender & PWL Capital in Toronto for their phenomenal offer to be walked through the transition from a fee-strapped-investor to a DIY investor. Over the last few years I have started several times to move my investments, only to end up overwhelmed with my paperwork piled in a corner to look at ‘soon’. Today, after only 4 days of working with Justin and Shannon, I feel relieved for their help, confident it will all work out, and excited to finally be attaining a goal that I was unable to accomplish on my own.
Thank you Justin, Shannon, & Pwl Capital in Toronto Centre for the generous donation of your time in order to help other investors and The Centre for Addiction and Mental Health (CAMH). Thank you also to The Canadian Couch Potato for being such a wonderful source of information.
Sincerely, Jerri
I’m consedering the new VSB for my bond portion, it is a good time to buy it now or it’s better to wait a few months till the market stabilizes
I’m in for the Quiken Draw
@Jerri: So great to hear that Justin was able to help you out. More proof that a good adviser can add tremendous value without selling products. Glad I could help spread the word.
@Bass: I would encourage you to avoid timing the market in any asset class. But the volatility in short-term bonds is especially low, so I can’t imagine when it would ever make sense to wait if you have money to invest.
Please count me in for the Quicken draw.
FYI, I’ve been enjoying reading your book…..great advice as always. If I read enough of this stuff enough times I stand a reasonable chance of retaining at least some of the knowledge!
Perhaps this could go in as part of your “Ask the Spud” series of posts as I have been wondering about your thoughts on it for some time now:
Speaking of what Jon Evan mentioned above…when ought one to change one’s asset allocation? John Bogle gave the advice to “hold one’s age in fixed-income” holdings for one’s portfolio, but when should one start changing one’s asset allocation? Is there an optimal time to adjust this? Has anyone crunched numbers on it?
I’m 22, so this is something that concerns me as I will be needing to change my allocations as I age/accumulate.
Thanks for keeping up the blog. I read it every week.
@Maxwell: The “your age in bonds” rule is not a bad starting point, but it’s too simplistic. The right asset allocation comes down to assessing the time horizon of your investment, your target rate of return, and your tolerance for volatility. I deal with this in detail in my book. I’ve also done a few posts on this:
https://canadiancouchpotato.com/2010/11/10/ready-willing-and-able-to-take-risk/
https://canadiancouchpotato.com/2011/08/09/do-you-have-the-right-asset-allocation/
https://canadiancouchpotato.com/2010/03/09/how-much-risk-do-you-need-to-take/
Please enter me in the quicken draw! Thanks for the great tips and advice. Merry Christmas!
These days there’s nothing wrong with a 60-70% weighting in bonds. There is a real risk of severe global recession or depression. If you crank up the income on your equities and your bonds you can potentially decrease volatility even more.
I add Canadian Bank Covered calls from bmo (zwb) to a version of the yield hungry portfolio. It pays 9-10% income, but you sacrifice some potential capital gains with covered calls. I know Dan won’t recommend it as it’s managed.
When you have a high income portfolio you can reinvest the income ‘house money’ and I can tell you that during volatile times, it’s easier emotionally to throw house money at equities, compared to ‘new’ monies that you’ve earned via pay cheque.
Throughout the recent roller coaster ride my model portfolio never went below 2% of its all-time high.
I’ll admit also to adapting to the macro environment by adding pipeline / utilities to the mix to increase the defensive nature of the equity portion. Those holdings are near or at all time highs and played a role in keeping the portfolio near its highs.
You can use xut or other indexes. Gold is a must as well.
So perhaps I have the uber -defensive high income couch potato portfolio?
Come to think of it, Dan, I’d be curious to see what your uber-defensive portfolio reco would look like. I think many would be interested in very very minimal volatility moving forward.
Thanks…
at 47 years old I have just been saving concertedly for about 3 years now and trying to learn as fast as I can, as I see the horizon shrinking ahead of me. Am enjoying reading the blog, which was recommended by the Wealthy Barber. I have everything in balanced mix of index funds through RBC and company group plan with Manulife, but looking to keep learning where I can squeeze a little more returns and efficiency out of my $. This a great place to be for that! Please include me in the draw. A tool like that might be a big help to someone in my situation. Regards all.
It’s that time of year again… time to re-balance the portfolio. Love reading the blog – lots of sound advice.
@Dale: You raise a lot of interesting questions. One of the pillars of the Couch Potato strategy is that making tactical moves (such as changing your bond allocation, or moving to defensive equity sectors) based on macro calls is not likely to deliver better performance than simply sticking with a long-term strategic allocation. This is just another form of active management.
The research suggests that the best way to lower volatility in a portfolio is to adjust the balance of equities and high-quality bonds. This is a simple but important concept that I think I will explore in a future post.
One point I would make is that investment returns from any source are not “house money.” Any income you receive from an investment is your reward for incurring risk. Considering “new money” to be different from “house money” is mental accounting, and it’s a significant behavioral bias that many investors struggle with.
@KerryB: Welcome to the blog, and hope you find it useful. Sounds like you’re on the right track, and at 47 you still have plenty of time to meet your goals. Cheers.
Thanks Dan. Though my macro ‘responses’ have proved fruitful. I was heavy into materials and gold in 2010 and had an over 60% return in that portfolio (separate from my model portfolio account). And my conservative gold and utilities and bond allotment has me well ahead of a basic model portfolio.
But as they say, past gains do not guarantee future results.
All said my strategy will likely pay off handsomely in that I will go to 60-70% equities when people are puking on their shoes. As you wrote previously in a response to me, if I can do that, I will make a lot of money.
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? Using total stock market and US and Canadian bonds. Id’ guess 80% bonds 20% equities. As equities and bonds can be inversely correlated much of the time.
Please enter my name in the draw. Thanks for the fantastic website!
Thank you couchpotato, Over the past 6 months I have really been trying to become financially literate. I’ve been reading lots of books and getting excited to learn all about investing. One book “A smart Canadian Wealth Builder, by Peter Dolezal” brought me here, I am stoked to get myself on the right track. Please enter me into the draw!!! Thank you
I have learned a lot from your site couchpotato. I am one of the lucky ones with a defined benefit ( but not indexed ) pension. I suppose that this means I can substantially increase the percentage in equities since I will always have the pension to tide me over.
I would like to participate in the draw as well. Thanks.
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
@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.
@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.
@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:
https://canadiancouchpotato.com/2010/08/20/td-responds-to-e-series-concerns/