The New York Times had a piece this weekend that proposes a simple portfolio solution for worried investors.
Are you ready for this?
The portfolio is a 50% allocation to stocks and 50% to bonds. The conclusion that the 50/50 portfolio makes sense is based on a study by Vanguard published in October 2011 that finds that this allocation seems to generate consistent returns, regardless of whether the economy is in recession or expansion. The study is based on portfolio performance from 1926 through June 2009.
The 50/50 portfolio generated an average annual return of 7.75% per year during recessions and 9.9% per year during expansions. 
If you subtract inflation, the average real return (return – inflation) is 5.26% per year during recessions and 5.59% per year during expansions. The purpose of this analysis seems to be two-fold:
1) To show that a 50/50 allocation has provided attractive returns with fairly modest risks over very long periods of time.
2) To discourage investors from trying to apply ‘tactical’ asset allocation to avoid market downturns.
As I read this piece, three things came to mind.
1. Bogle’s Vindication.First, while this paper is based on a detailed analysis of a long market history, John Bogle (Vanguard’s founder, now retired) has advocated a 50/50 portfolio for many years. In an outstanding essay from 2001, The Twelve Pillars of Wisdom, Mr. Bogle proposes the following:
"There are an infinite number of strategies worse than this one: Commit, over a period of a few years, half of your assets to a stock index fund and half to a bond index fund. Ignore interim fluctuations in their net asset values. Hold your positions for as long as you live, subject only to infrequent and marginal adjustments as your circumstances change. When there are multiple solutions to a problem, choose the simplest one."
Investors who followed this guidance back in 2001—a decade ago—are likely better off for it.
2. Beware of Hindsight Bias.The second thing that strikes me as I read this new Vanguard study, is that it falls prey to hindsight bias. After a dismal decade for equities, it is fairly clear that a 50/50 portfolio would have been a good idea in retrospect. What about if we look forward? Interest rates are near record lows. What would have to happen for the 50/50 portfolio to generate an average of 8% or so in the future?
Over the past 15 years, Vanguard’s Total Bond Market Index Fund (VBMFX) has returned an average of 6.02%. Over this same period, Vanguard’s S&P500 Index (VFINX) has returned an annualized 5.33% per year. Clearly, there is no combination of these two index funds that can possible generate annualized returns greater than 6%.
When I run my Monte Carlo simulation using all baseline settings—I get a projected annual return of 5.4% per year for a portfolio that is 50% allocated to VFINX and 50% allocated to VBMFX. This is very close to what you would have generated over the past 15 years in the 50/50 portfolio. These levels of returns are a far cry from 8% per year, that this portfolio has apparently generated if we go all the way back to 1926.
For the 50/50 portfolio to generate 8% per year (5% in real return), either stocks or bonds will have to substantially out-perform their returns in the last fifteen years. Given that bond yields are near record lows (and bond yields are a pretty good predictor of their future returns), the only way that the 50/50 portfolio will generate returns near 8% will be if stocks have a substantial rally. The likelihood of such a thing is not something that we can possibly predict.
3. What About Broader Diversification?The Vanguard study, and the New York Times article based on it, is intended to show that a diversified portfolio can weather the ups and downs of the global economy. While this is true, I believe that care is required in using these results to guide our expectations.
I am a firm believer in the value of diversification, but I am fairly concerned that a simple mix of the S&P500 index or a global market cap weighted index with an aggregate bond fund is not, in fact, as well diversified as we can get. Effective diversification requires a broader view—such as we have used in creating the Target Date Folios. As Rob Arnott famously noted, a portfolio that is 60% allocated to the S&P 500 and 40% allocated to a bond fund still has a 99% correlation to the performance of the S&P500. Similarly, the 50/50 portfolio’s returns have a correlation of 98% with the returns from the S&P500.
The 50/50 portfolio, for all of its virtues, is simply not all that well diversified. By not fully exploiting available diversification benefits, the future returns from such a portfolio are at risk of under-performing relative to the risks that investors bear.
Final Thoughts on the 50/50 SolutionIt is not unreasonable to take the position that a simple 50/50 portfolio is likely to be better than many other asset allocations that investors could chooseas Mr. Bogle suggested ten years ago. I believe that it is a mistake to simply assume that such a portfolio is in any way optimal. If there were reason to believe that the 50/50 portfolio would provide 7.75% - 9.9% average annual returns in the future (as it has in the historical period analyzed by Vanguard), I would be very enthusiastic about this low-cost simple portfolio. The problem is that our ability to project future returns for this (or any other) portfolio is extremely limited. As such, it seems judicious to diversify beyond a simple mix of stocks and bonds.
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