Portfolio Design: A Modern Approach to Asset Allocation

SO WHAT HAPPENS WHEN THE ECONOMY TURNS Up?

In the middle of a downturn in the U.S. economy, a substantial fraction of investors abandon stocks for good. That’s a sensible strategy if the investors are so rich that they can afford to hide out in Treasuries or other types of bonds. With a real return of 2.4 percent, they had better be rich! A $ 1 million dollar portfolio earns only $24,000 in real terms (pre-tax). Try living on that in retirement. But spending 2.4 percent would be imprudent unless the investor was sure that inflation would not rise during retirement. As Chapter 15 will show, an investor needs to keep spending considerably below the expected real return on investments. So an all-bond investor would have to make sure that spending was substantially lower than 2.4 percent. That’s a depressing prospect.

But there is another reason why investors need to keep their faith in equities, especially after they have been clobbered with a market downturn. Equities always rise as the economy recovers. Let’s study past recessions. In every recession, equities will be traced from their trough during the recession over the 12 months succeeding the trough. Table 1.5 lists dates for the nine recessions since 1951 including the second half of the double-dip recession(s) of 1980–82.

TABLE 1.5 S&P 500 Rallies After Recessions, 1951–2010

Recession months	Gain in first
(NBER dating)	Market Bottom	12 months
Jul 53–May 54	Sept 53	46.0%
Aug 57–Apr 58	Dec 57	43.4%
Apr 60–Feb 61 ...