The stock market in 2020 can be described as unexpected and highly volatile. With a sharp sell off in February-March to an equally impressive V-shaped recovery. High volatility increases anxiety and can force investors to make poor decisions about investments. Investors may not be able to control their emotions, but they can control how they invest. For risk averse investors, selecting a model with lower volatility is a prudent decision. A risk averse investor is more likely to tolerate small losses and stay invested long-term with lower volatility portfolio.
Recessions and the stock market corrections give pain1 to many investors. After the financial crisis of 2007-2008, I researched the investment strategy that could withstand such pain1 and provide enough protection. This strategy is called the simple 50/50 asset allocation model referred to as the model in this paper. For the original and more detailed research, you can visit my earlier post located here: https://ecnfin.com/2012/10/07/simple-5050-asset-allocation-model-proven-to-withstand-the-financial-crisis-of-2008/
The simple 50/50 asset allocation model is based on 50% of the money being invested in the US Equity Market Index and another 50% in the long-term US Treasury bonds. In this article, I will use iShares Core S&P 500 ETF ticker (IVV) to gain exposure to the stock market, and iShares 20+ Year Treasury Bond ETF ticker (TLT) to gain exposure to the US Treasury bond market. I assume 50% of the money is invested in IVV and 50% in TLT. Now let’s review how this simple 50/50 model have done to withstand the Covid-19 pandemic in 2020.
The simple 50/50 model protected on the downside and provided upside returns during the Covid-19 stock market v-shaped recovery. The simple 50/50 asset allocation model earned 18.12% with daily rebalancing and 16.35% with monthly rebalancing from January 1, 2020 – August 28, 2020. While S&P 500 Index earned about 10.03% (see Table 1).
Besides better returns, the simple 50/50 asset allocation model has lower volatility than the market (see chart 1). Looking at the monthly returns from January through August 2020, the biggest losses were in March when the model lost -1.44% with daily rebalancing or -2.88% with monthly rebalancing. In comparison, the S&P 500 Index was down -12.13% in March 2020 (see table 2 and chart 2). For a risk averse investor by being down more than -12% in one month will inflict great amount of pain1. Such investor may decide to sell when the losses are great trying to avoid the pain.
When the risk averse investor sells during the stock market correction, he or she will not participate in the future potential stock market recovery. For example, the next month after the sell off, the S&P 500 Index was up by more than 12% (see table 2 and chart 2). It was a V-shaped recovery with a high volatility and great amount of pain initially, followed by a steep recovery.
The simple 50/50 asset allocation model can be more suitable to risk averse investors. It can provide lower volatility which translates into less pain1. With less pain, investors maybe more willing to stay invested long-term. The model tends to have equity like returns as well. Investor will participate in the stock market. The model was successful at hedging downside risk during the financial crisis of 2007-2008 and the Covid-19 selloff.
1 Pain – Loss aversion is a cognitive bias. For individuals, the pain of losing is psychologically twice as powerful as the pleasure of gaining. The loss felt from money, or any other valuable object, can feel worse than gaining that same thing (Kahneman, D., & Tversky, A. (1977). Prospect Theory. An Analysis of Decision Making Under Risk.)
Yahoo! Finance. S&P 500 Price, TLT and IVV Data was retrieved from http://finance.yahoo.com
The simple 50/50 asset allocation model is one of the tools that investor may consider, but it may not work for everybody. There is no one magic formula for all market conditions. The future performance of the model will vary greatly based on the stage of the business cycle. The model may underperform the stock market in the future. iShares 20+ Year Treasury Bond ETF (TLT) has long duration and high interest rate risk. When rates increase, the price of TLT will decline. With significant and unexpected increase in interest rates, both fixed income and equity markets may decline.
The analysis is based on historical data and future expectations that may not be correct. This paper was written as an opinion only. The data is not guaranteed to be accurate or complete. Please consult with your financial advisor before making an investment decision.
ECNFIN.com and its podcast are not associated with nor do they necessarily represent the opinion or advice of Epiqwest Culver Wealth Advisors LLC. Past performance doesn’t guarantee future results.