Equity investors are again taking it on the chin in 2002. In July the NASDAQ was down well over 70 percent from its highs posted in 2000. The Standard and Poor’s 500 was making new five-year lows and the Dow Jones Industrial Average was off almost 4,000 points from its all-time highs. Investors were left wondering how to best allocate their assets to rebound from the losses suffered during this bear market.
We will explore lump sum and dollar cost averaging investment strategies using a commonly prescribed asset allocation. Asset allocation refers to the division of investment dollars between asset classes such as bonds, cash, equities, real estate, and derivatives and is a diversification strategy that allows investors to reduce the risk of their investment portfolios. But does asset allocation also reduce the rewards?
Chief Investment Strategists often offer suggested asset allocations. For a guideline asset allocation, we turn to SmartMoney.com’s top-ranked pundit, Goldman Sachs’s Abby Joseph Cohen who, one year ago, recommended investors put 70 percent of their funds in equities, 27 percent in bonds, and 3 percent in commodities. To simplify, we use a 70 percent equity (stock) allocation and a 30 percent debt (bond) allocation as our blended portfolio to examine historical returns for model portfolios. We also apply the same allocation to see how long it would have taken to recover from market downturns going back to 1926.
Historical Returns Favor Stocks Over Bonds and Blended Portfolios
In order to investigate the asset allocation question, we examine the historical annual bond and stock returns from 1926 to 2000. The 1926 to 1999 data come from Stocks, Bonds, Bills, and Inflation: 2000 Yearbook. The 2000 data were obtained from Yahoo Finance. Stock returns are calculated using the Standard and Poor’s 500 (S&P 500), a large-cap stock index. The long-term corporate bond fund is a portfolio of high-quality corporate bonds with a 20-year maturity.
Using these stock and bond data, we also create historical returns for a blended fund that consists of 70 percent stocks and 30 percent bonds. This fund is rebalanced annually at the beginning of the year to recalibrate to the 70/30 allocation. Also, we assume reinvestment of dividends and coupon payments on an annual basis.
Our first exercise is to calculate the market performance of different allocation strategies based on a lump-sum deposit in 1926. For comparison, we also calculate performance based on equal annual deposits over the sample period.
Panel A of the following table highlights the annual returns for each asset class (stocks and bonds) from 1926 to 2000. Using 1926 as an example, if you were to invest in the stock portfolio, you would have earned 13.7 percent. If, on the other hand, you invested in the bond portfolio, your return would have been 7.0 percent. During the entire sample period, equity securities, on average, earned 12.84 percent while bonds earned 6.26 percent. Clearly, all else equal, we would prefer to put all of our money in stocks over the longer time horizon to earn the higher return. So, what is the downside risk from doing so?
Panel B of the table highlights the market performances from allocations of 100 percent equity, 100 percent debt, and a 70/30 blend. Take a look at the stretch of years between 1929 and 1932. If you invested $1 in stocks on January 1, 1929 (not presented in the table) and checked its value on December 31, 1932, you would have discovered that your investment was only worth 35 cents. If, however, you invested in bonds, you would have an investment value of $1.21, which is over three times the stock investment value. Is the risk associated with equity investments rewarded on average? If not, few investors could afford (and none would rationally choose) to subject their portfolios to those risks. The return data provides a historical perspective on allocation strategy performance.
So how have the asset classes fared over the longer term? If an investor allocated $1 to equity in 1926, her portfolio would have grown to $2,314 at the end of 2000. If the same investor had allocated $1 to debt, her investment would have a value of $81 at the end of 2000. As of December 31, 2000, the stock portfolio is approximately 29 times the value of the bond portfolio.
But Stocks are More Volatile
The stock returns are more volatile, however. One way to reduce some of the volatility would be to prescribe to the asset allocation of 70 percent stocks and 30 percent bonds. If one were to use this allocation strategy, his portfolio would have grown to $1,137, which is much better than the bond portfolio value but substantially less than the stock portfolio value. The results are very clear. If, over a longer-term horizon, stocks outperform bonds and blended funds, why would anyone invest in anything other than stocks? Further, why do Chief Investment Strategists, on average, recommend that investors allocate 70 percent of their assets to stocks and 30 percent to bonds when stocks outperform blended funds? These questions will be answered below.
Panel C of the following table illustrates the years required for an equity allocation to outperform both the long-term bond portfolio and the annually-rebalanced stock/bond fund. Using 1926 as an example, if one invested in equity at the beginning of the year, her stock portfolio value would have exceeded the bond and stock/bond portfolios by the end of 1926, or within one year. The worst year to put 100 percent in stocks would have been in 1929. If one invested in the stock portfolio at the beginning of 1929, it would have taken him 22 years to surpass the value of the bond portfolio and 26 years to surpass the value of the annually-rebalanced stock/bond portfolio. This is the main reason investors need to consider their time horizon when allocating assets.
Allocation return differences during 1929 are the most extreme case, however. When considering the post-Securities Exchanges Act of 1933 and 1934, which redefined the market and the risks associated with investing, the time horizon for investing during “bad” years is reduced to single digits. Casual observation tells us that stocks, more times than not, outperform bonds and blended funds within 1 year. Of the 74 years, stocks outperformed bonds 62 percent of the time within just 1 year and 96 percent of the time within 4 years. Similar to the bond fund results, stocks outperformed the stock/bond fund 62 percent of the time within just one year and 95 percent of the time within 4 years. On average, stocks outperformed bond funds in just 2.65 years and stock/bond funds in just 3.22 years. The risk occurs if we invest in a bad year, such as 1929, and it takes 26 years to catch-up to a balanced portfolio. If, however, our investment time horizon is sufficiently long, it appears foolish not to invest wholly in stocks since our returns would be greater.
In order to determine the benefits of periodic deposits, such as payments to a 401K or 403B, the following table examines a dollar-cost averaging (DCA) approach to allocation strategies. As in the previous table, Panel A highlights the annual returns for each asset class (stocks and bonds) from 1926 to 2000. Panel B highlights the DCA market performance from an allocation of 100 percent equity, 100 percent debt, and a 70/30 allocation. If you invested $1 per year in the equity allocation on January 1, 1929, 1930, 1931, and 1932, you would have discovered that your portfolio was worth $2.17. A portfolio of debt allocation would an investment value of $4.60, which is more than twice the stock investment value.
Investing $1 per year in equity securities from 1926 to 2000 would have generated a value of $37,568 on December 31, 2000. If the same investor had allocated $1 per year to debt, her investment would have a value of $1,835 at the end of 2000. As of December 31, 2000, the stock portfolio is approximately 20 times more valuable than the bond portfolio. If one were to diversify among asset classes with 70 cents in stocks and 30 cents in bonds, his portfolio would have grown to $17,398, which remains less than half the stock portfolio value. Again, over a longer-term horizon, stocks outperform bonds and blended funds.
Dollar Cost Averaging Favors Stocks
Panel C reveals an interesting result. The time horizon for equity allocation values to surpass debt allocation values is reduced dramatically under a DCA investment strategy. The 22 years needed for the equity allocation value to surpass the value of the bond portfolio is reduced to 7 years in 1929. Likewise, the 26 years needed for the equity allocation values to surpass the value of the stock/bond portfolio is reduced to 7 years. On average, the time required for stocks to outperform bond funds is just 1.72 years and stock/bond funds is 1.78 years. A prudent investor with a long-term horizon, greater than 7 years when a DCA strategy is implemented, would always allocate 100 percent of her assets to equity, based on historical data. Other considerations can alter the asset allocation strategy, however.
The evidence suggests that, although more risky, stock investments provide returns that are superior to both bonds and the bond/stock blend. For the entire time period, the stock returns provide an ending asset value that is more than 28 times the bond value and more than more than twice the value of the stock/bond blend. Some further considerations follow.
Any rational investor would prefer to have a 12.84 percent average return from investing in stocks instead of a 6.26 percent return from bonds but what is the downside? The risks come in the form of needing the investment monies at a time when the stock portfolio may be under performing an alternative investment, such as a bond portfolio or blended portfolio. Accordingly, if an investor’s time horizon is relatively short, he may wish to invest in safer securities such as bonds to ensure a relatively predictable future asset value. If, however, one is investing for retirement that is 30 years away, he should consider investing solely in stocks (depending on the individual’s risk preferences).
The stock fund is invested in the Standard and Poor’s 500 (S&P 500). The S&P 500 is an index that has relatively low turnover and thus, few realized capital gains. The bond fund also has few capital gains. The balanced portfolio, to maintain a 70/30 balance, requires the owner to reallocate assets at some prespecified time interval. Since the asset class with the largest gains is sold to reallocate to the prescribed 70/30 split, capital gains are realized. Tax impact calculations would further reduce the value of the blended fund relative to the stock fund.
Transactions costs are another advantage to owning a basket of equities, such as the S&P 500. If one prefers to hold a 70 percent weight in stocks and 30 percent in bonds, transactions costs will depend on the rebalancing interval. Since it is unlikely that both stocks and bonds will increase or decrease in value by the same percentage over a given time horizon, it will most likely be necessary to either sell bonds to purchase stock or, alternatively, to sell stock to purchase bonds. The result is additional transaction costs, which could be avoided by purchasing a large-cap stock fund.
The average inflation rate over the time period studied, 1926 to 2000, was approximately 3.2 percent per year. Inflation erodes the purchasing power of future values. For example, if you purchased $1 in stocks in 1926, your nominal value would be $2,314 in 2000 but inflation would have eroded one’s purchasing power to $217.96 in 1926 dollars. Inflation would have eroded the real value of the bond investment to $7.63 in 1926 dollars.
The stock returns are calculated with reinvested dividends. Likewise the bond returns are calculated with reinvested coupon payments. Automatic reinvestment can be efficiently achieved by purchasing mutual funds but would be costly if one were to create a homemade portfolio.
We all wonder what the duration of the current bear market is going to be and how we might best position ourselves for a timely recovery. One way to expedite our personal recovery is with a suitable asset allocation. Allocating assets is a task that is very individual-specific and depends on risk preferences and investment time horizons. Over time, it is no surprise that equities outperform bonds but the question is … How long will it take to recover from the bear market? It depends on your asset allocation.