Investors May Find 50-50 Solution Best Strategy
The euro crisis is deepening, the government in Washington can’t cut the deficit or reduce unemployment, and the economy is lurching into recession.
For investors, the course is obvious: Seek safety, and avoid risky assets like stocks.
All of that may seem clear enough. Since August, it has often been the prevailing view in financial markets. But it’s not the only narrative, and it hasn’t always been the dominant one.
In fact, another argument has received considerable support lately.
It goes something like this: Recent economic data have been surprisingly strong, showing that while the economy is weak, it’s not in a recession, at least not in the United States.
As for the crises in the euro zone and in Washington, the politicians will just have to come to their senses before the situation really gets out of control.
For investors, the course is obvious: Jump into stocks. Don’t miss the big rally.
It may be hard to decide which picture makes the most sense.
Perhaps each is appealing, sometimes one more than the other, depending on the news of the particular moment. These days, paying close attention to the economy and the markets can cause whiplash.
What should an investor really do? In a word, nothing.
When the latest news tempts you to move your investments around, take a deep breath. Unless you need the cash soon, the best course of action may be inaction.
That’s the import of a recent study by the Vanguard Group. Assuming you’ve already set up a diversified portfolio, sitting tight may make the most sense.
Vanguard created a model portfolio divided equally between stocks and bonds, and compared the returns in periods of economic expansion and recession. It found that “the average real returns of such a portfolio since 1926 have been statistically equivalent regardless of whether the U.S. economy was in or out of recession.”
Vanguard’s founder, John C. Bogle, popularized index funds, and the study tracked the stock and bond markets using indexes that mirror the broad markets. Individual stock and bond selection wasn’t involved at all.
The study, titled “Recessions and Balanced Portfolio Returns,” used the official recession dating of the National Bureau of Economic Research to compare market returns throughout the up and down phases of the business cycle from 1926 through June 2009.
During expansions, the model portfolio had average real returns, factoring in inflation, of 5.6 percent, compared with 5.3 percent during recessions.
In short, there was a difference, but it was too small to be of any statistical significance, says Joseph H. Davis, chief economist and head of the investment strategy group at the Vanguard Group and a co-author of the report. (The other author was Daniel Piquet of Vanguard.)
When the economy was bad and when it was good, the portfolio performed more or less the same. It really didn’t matter.
“The results may seem counterintuitive,” Mr. Davis said in a telephone interview. “You might think that it’s best for investors to avoid a recession, and in some ways, of course, it is. No one wants a recession. But the results suggest that as investors, rather than try to time the market, most people are best off with a diversified portfolio and just sticking with it over the long run.”
What accounts for these results? Put simply, bonds tend to outperform stocks when a recession is on the horizon, while stocks tend to rally when an economic expansion is in the offing.
“The financial markets themselves tend to move in advance of the economy,” Mr. Davis said.
Predicting the economy’s direction is famously difficult. So unless you have substantial bond holdings in your portfolio well before a recessions begin, you’ll miss upturns in the bond market.
And unless you’re holding stocks before an economic recovery has started, you’ll miss those big rallies.
By holding stocks and bonds in equal proportion — a portfolio that’s easy to construct by using index funds — you won’t need to be prescient; you can stick to your portfolio and ride out the storms.
Of course, a 50-50 stock-bond division is relatively conservative. Alter those proportions and the results will shift significantly.
During recessions, for example, a portfolio containing 60 percent stocks and 40 percent bonds fared worse than the 50-50 portfolio, with an average real return of 4.9 percent annually.
In expansions it did better, with an average real return of 6.8 percent, according to Vanguard’s calculations.
That points out the allure of market timing.
In an ideal world, if you knew in advance where the economy was heading, you’d be a market wizard. You would shift your entire portfolio into stocks during expansions, for example, and put all of it into bonds in recessions.
If you could actually do this, the results would be impressive.
In expansions, Vanguard found, stocks have gained an average of 11.9 percent annually, after inflation, while the comparable figure for bonds in recessions is 7.2 percent That kind of timing is ideal.
But it’s easy to shoot yourself in the foot.
Get the timing wrong and hold only stocks in recessions, for example, and you’d have an annual average gain in those periods of 3.3 percent, after inflation. And if you hold bonds in expansions, you’d lose an average annual 0.7 percent, also after inflation.
It may be possible to predict the rough direction of the economy some of the time, but there’s no evidence that anyone gets it right all the time.
“I’d be very careful before assuming that I knew better than the overall market,” Mr. Davis said.
It turns out, though, that if you have a diversified portfolio and are prepared to hold onto it, you may not need to know where the economy is going.
In other words, humility may bring the steadiest returns.