Portfolio Design: A Modern Approach to Asset Allocation

PORTFOLIOS OF STOCKS AND BONDS

Because risk is central to the success or failure of spending rules, we will try to reduce risk by diversifying the portfolio. Instead of being based on the Treasury bond alone, the bond returns are based on the Barclays Capital Aggregate Index. In the case of stocks, both foreign and domestic stocks are included in the portfolio, with foreign stocks set at one-third of the total stock allocation. Foreign stocks are represented by the Morgan Stanley EAFE index, while U.S. stocks are represented by the Russell 3000 index rather than the narrower S&P 500 index. A portfolio consisting of these three assets provides additional (admittedly modest) diversification relative to a portfolio with Treasury bonds and the S&P 500 index alone. With foreign stocks representing one-third of the stock portion of the portfolio, a 75/25 stock/bond portfolio consists of 25 percent in the Barclays Aggregate index, 50 percent in the Russell 3000 index, and 25 percent in the EAFE index.

There is one drawback to choosing such a diversified mixture of stocks and bonds. As explained in Chapter 8 on asset allocation, the three indexes chosen begin in the 1970s, not in 1951. If the returns on these indexes were used without modification, the series would be measured beginning in 1979, the first year when the shortest index, the Russell 3000 index, is available. That would mean that the simulations would be based on the high real returns of the 1980s and 1990s bull market. Instead ...