Several years ago, a mutual fund company’s research reportedly showed over time, a mix of 30% fixed income, 70% equities produced the same return as a more aggressive combination of 70% stocks, 30% fixed income. That’s certainly an attention-getter, especially since investors are always taught riskier portfolios should be expected to produce higher returns over time. Unfortunately, we’ve long forgotten the name of the fund company and the specific time frame of the research. What did stick was the fact that portfolios with such severe differences in risk resulted in the same return.
It’s often said that statistics don’t lie, but if tortured enough, they may bend the truth a little. While we don’t doubt the fund managers’ findings — it was published albeit with a fair amount of fine print — what is worth questioning is the extent of its validity. In this case, how long was the “long term”? Was the research conducted over one specific time period or many? Are the results a trend or more likely an aberration?
It’s would seem easy to recreate the study: Just build two portfolios and compare their historical results. We used the Barclay’s (formerly Lehman Brothers) Aggregate Bond Index to represent a broad base of fixed income and the S&P 500 as proxy for the equity allocation. We used the time period September 1976 through September 2012 to get the most up-to-date results and the longest common time period. To maintain the distinction between the two portfolios, we rebalanced them back to their original allocations at the end of every month.
The results are interesting and do support the fund firm’s findings. On the other hand, they can be quite contrary as well.
The overall results aren’t surprising. Chart 1 is a typical “mountain chart” that shows the growth of a dollar initially invested in 1976. This is the cumulative return which adds each year’s gains and subtracts any losses. Not surprisingly, the 70/30 riskier portfolio (yellow line) outshines the more conservative 30/70 alternative (orange line). Risk, it would seem, was rewarded.
But there are two very important things to bear in mind. First, the specific time period measured by a mountain chart can have an important bearing on its results. More specifically, the order of returns can play a major role in the outcome. In this case, the riskier assets got off to a strong start in the first few years and were able to ride the lead over the more conservative portfolio throughout the rest of the measurement period. This was true even in the past decade when stocks suffered two bear markets. Had the bear markets come first, the ultimate outcome would have likely been reversed.
Secondly, this is a measure of one specific time period. If you were an investor in 1976 with a 36-year time horizon, you’d have been well served in the 70/30 portfolio. But what if you had a shorter time horizon or started investing at a different point in time? The data graphed in Chart 1 doesn’t address these questions.
You can get a better idea of the extent — and the source of the mutual fund company’s findings — from Chart 2 which shows the returns of 5-year holding periods. Unlike the previous chart which covered a distinct period, Chart 2 is made up of rolling period results. Rolling periods in this case calculated by annualizing returns for each of the 60-months periods from September 1976 – September 2012. The bars on the chart represent the results for the holding period ending on the displayed date. Using rolling periods it’s possible to get a better feel for what an investor with a particular time horizon (in this case 5-years) could expect regardless of the particular starting point.
Chart 2 clearly shows investors in this century with 5-year holding periods were more likely to enjoy better results with lower risk 30/70 portfolios. Wow! That’s a shocker.
Or is it?
After the big runup of the 1990s, stocks suffered a sharp, deep blow-off and subsequent bear market in 2001 and 2002. A recovery followed only to see the major declines from the credit crisis of 2008 leading to the second bear market in the span of five years. No wonder aggressive portfolios struggled while conservative portfolios focusing on bonds — which enjoyed a significant bull market — outperformed. Looking back over the past 12 years, no matter which 5-year holding period is selected, it contains one, if not multiple, down years for stocks. Not only that, the depth of the decline is hard to overcome with such a short investment horizon, just like a bad start on a mountain chart.
So yes, the findings from the mutual fund manager were true, yet that still doesn’t answer the real question. While it may be true investors with short-term holding periods should have invested conservatively in the past decade, it’s equally true you can’t go back in time to join them now. The past twelve years were kind to fixed-income heavy portfolios, but what’s more important is will this continue to be the case in the future? That’s the only place you can take advantage of this finding. It’s also the implication of the fund firm’s advertising.
Unfortunately, history doesn’t bear this out. If you look back at Chart 2 you’ll notice the more aggressive allocation dominated in the years leading up to 2000. If anything, the two sharp bear markets of the 2000s are probably an anomaly along with the superior performance of the 30/70 portfolio.
Could the past twelve years represent a change in the market or a new trend? That’s possible, but not likely. Consider the fixed-income bull market which has been powered and sustained by the Federal Reserve’s easy money policy. At some point, the economy will stabilize and the Fed will let rates rise back towards more natural levels. In fact, if inflation looms as many fear, rates may actually have to go higher. If so, prices of fixed income investments which move inversely with prevailing rates, will decline, taking the 30/70 portfolio along with them. Odds are the recent outperformance of the 30/70 portfolio is more likely a result of the cyclical fixed income bull market than a tradable trend for the future.
Longer-term rolling periods (e.g. 10 or 20 years, not illustrated here) also bear this out. Over these periods there have been extremely few times when an investor with a longer-term investment horizon would have fared better in the 30/70 portfolio. This is critical information for the long-term investor or the retirement plan participant with ten years or more before retirement. Just as the short time frame can color specific results, extrapolating recent 5-year holding periods can be equally misleading.
In this case, neither the statistics nor the fund company lied, but the truth is less than advertised. That, too, should not be surprising.