In Defense of the Humble Balanced Portfolio

My colleague John Rekenthaler wrote a recent piece that defended a buy-and-hold investment strategy, and it generated some heated debate. So I thought I'd take his argument one step further and look at how the humble balanced portfolio (50% stocks and 50% bonds as represented by the S&P 500 and BarCap US Aggregate Bond indexes) has performed for the trailing 10 years through Aug. 31, 2009, and for the painful period from Jan. 1, 2008, through Aug. 31, 2009. I also took a look at some of our favorite moderate-allocation and world-allocation funds, though they tend to have about 60% stock exposure and 40% bond exposure.

The results show that an investor did pretty well over 10 years with a balanced allocation or a good moderate-allocation fund and not so badly over the past 20 months. My conclusion is that those respondents to Rekenthaler's article who griped about performance and purveyors of a buy-and-hold strategy have either been in bad allocations or are unable to tolerate quotational declines. I don't mean to minimize the pain that 2008 inflicted on many investors or the poor decade that stocks have had in general, but having a modest asset allocation and, yes, hanging on through thick and thin have minimized damage considerably.

The Indexes for a Decade
First, for the 10-year trailing period through Aug. 31, 2009, the S&P 500 Index lost 7.7% cumulatively, while the BarCap US Aggregate Bond Index has gained 84% cumulatively. That means a portfolio split evenly between these two indexes on Sept. 1, 1999, and never rebalanced produced a roughly 38% cumulative return for the past decade. That's nothing to write home about, but it's also clearly far from catastrophic.

Our Moderate-Allocation and World-Allocation Analyst Picks for a Decade
So, how did some of our favorite moderate-allocation and world-allocation funds do for the decade through Aug. 31, 2009? Even better than the indexes. There are eight funds that we've designated as Analyst Picks in those two categories, and their average cumulative return for the decade was 74%. The two world-allocation Analyst Picks averaged more than 100%, so, on the whole, they did better than the purely U.S.-oriented funds. The worst option in the two categories still returned 59% cumulatively--not stellar, but nowhere near awful either (and incidentally, well ahead of the 38% return of the combined indexes).

The Indexes for the Past 20 Months
But what about the last 20 months? Haven't the declines in balanced portfolios been dreadful?

As it turned out, not really.

From Jan. 1, 2008, through Aug. 31, 2009, the S&P 500 Index lost 28% cumulatively, while the BarCap US Aggregate Bond Index gained 10%. So, a portfolio split between those two indexes and never rebalanced is down around 9%. Is a 9% loss bad over 20 months? It's not great, but it's totally within the realm of reason for an investor with half of his or her assets in stocks. If you can't handle that, you have a very low risk tolerance indeed and should reconsider whether 50% stock exposure is reasonable for you.

Let's translate a 9% loss into dollar values. If you started with $100,000 on Jan. 1, 2008, you had $91,000 on Aug. 31, 2009. If you started with $500,000, you ended with $455,000, and if you started with a cool $1 million, you ended with $910,000. Nobody likes to lose money, especially $90,000, but to call these losses catastrophic on a percentage basis is overstating the matter. A 9% loss in all but the most conservatively allocated investment portfolios (that is, those with 25% stocks or less) simply isn't outrageous.

Our Moderate-Allocation and World-Allocation Analyst Picks over the Past 20 Months
What about our moderate-allocation and world-allocation Analyst Picks over the last 20 months? They've averaged a 15% loss, or 6 percentage points worse than the average of the two indexes. Part of that has to do with exposure to stocks simply. Most moderate-allocation funds have around 60% stock exposure, not 50% stock exposure. Also, moderate-allocation funds often like to pursue income on the stock side, and banks and other financials were typically paying the highest dividends before the financial meltdown.

Another reason for our picks' underperformance is that their bond portions have hurt them. The bond portions of moderate-allocation funds tend to resemble the typical intermediate-term bond fund, which underperformed the Aggregate Bond Index in 2008. These funds often hold more nongovernment fare than the U.S. Treasury-heavy index, which hurt when Treasuries rallied sharply while nongovernment sectors like corporate bonds suffered losses. The gains over the index in 2009, when corporates have rebounded, haven't been enough to wipe out 2008's underperformance yet. Although it's difficult to disaggregate the bond portions of balanced funds, using the intermediate-term category as a proxy makes us think it's likely the bond portions of our favorite funds have struggled over the 20-month period.

Ultimately, our moderate-allocation and world-allocation Analyst Picks have had a rough time of it lately, but again, a 15% loss of 20 months, though rather disconcerting, isn't outrageous for a group of funds with 60% or so exposure to stocks.

Just as important to note, as we circle back to Rekenthaler's buy-and-hold advocacy, is that our picks averaged losses of 26% for the 2008 calendar year. Even including the brutal start of the year, 2009 has seen our picks add another 11 percentage points, on average, to their cumulative return, making the whole 20-month period unpleasant, to be sure, but tolerable. Sticking with a balanced fund through 2009--even one that has underperformed a combined stock and bond index--has ameliorated a considerable amount of 2008's pain.

Conclusion
Although I have emphasized the virtues of balanced funds or a balanced portfolio in this piece and argued that a roughly even split between stocks and bonds has held up reasonably well over the long and short terms, it's true that a static 50/50 stock/bond split isn't right for everyone. If you're under 30 years old, even under 40, you'll likely want more stock exposure, making the recent stock market declines more painful than I've indicated they were for our favorite moderate-allocation funds. On the other hand, if you're getting deep into retirement, you probably want less stock exposure than a balanced fund provides, making recent market declines less painful than I've indicated.

It's worth noting, however, that no less an authority than Warren Buffett's teacher, Benjamin Graham, in his classic book The Intelligent Investor, thought that a roughly even split between stocks and bonds at virtually all times was the prudent course for the vast majority of investors. Any more than half of one's assets exposed to stocks seems to cause inordinate pain in precipitous and protracted market downdrafts, while any less than half of one's assets exposed to stocks seems to cause inordinate envy and greed during market surges. The former encourages selling near bottoms, while the latter encourages buying near tops, two classic forms of investor bad behavior.

The first-order investment question, then, is what allocation is right for you, which basically means what amount of stock exposure you can handle without being overcome by fear and greed during market gyrations. Think hard about what allocation is right for you, and you'll be able to use a buy-and-hold strategy to avoid selling low and buying high.

A classic buy-and-hold strategy does work--provided you're in a reasonable allocation in the first place. Occasional rebalancing, which means selling some stocks during a market surge and buying some stocks during a decline to keep yourself at 50/50 or whatever your prearranged allocation is, makes good sense as well.