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Vanguard on booms and busts

By Sheyna Steiner · Bankrate.com
Friday, October 7, 2011
Posted: 11 am ET

Not to belabor the whole investing in a recession topic, but Vanguard released a paper this week, "Recessions and balanced portfolio returns," to address a common investor concern during economic contractions.

"Given the rising risk of a renewed U.S. recession, investors may wonder about the merits of a more 'defensive' posture for their broad portfolio," the paper begins.

To that end, Vanguard calculated the historic returns of a balanced portfolio, split equally between stocks and bonds in both recessionary and expanding economic times.

They found that the average returns on a portfolio split 50/50 between bonds and equities have been fairly similar regardless of the business cycle. The average annualized real returns between 1926 and 2009 were 5.26 percent in recessions and 5.59 percent in expansions.

Here's a little on why that may be:

The similarity in average real returns occurs largely because of two often-complementary forces at work in a balanced portfolio. First, when a recession is imminent, there is a tendency for bonds to outperform stocks during the initial period of economic weakness (a “flight-to-safety” effect).

Second, as illustrated by the trend line in Figure 3, on page 4, stock prices tend to decline before a recession officially begins and to rise before it officially ends (a “leading indicator” effect). For instance, 10 of the 20 highest-returning months for the U.S. stock market since 1926 have occurred during recessions, and 7 of the top 10.

Many younger investors may not have any bonds in their portfolio, and that's going to lead to increased volatility. But over time, it will even out. While bonds will make stock downturns easier to bear, they offer a limited return during boom times while stocks are going gangbusters. It's always a trade-off between safety and return.

Attempting to get the best of both worlds while completely avoiding any pain through market timing will often just lead to a stalemate, or in many cases, leave your portfolio worse than if you had simply done nothing.

The Vanguard paper details the complications with reacting to economic data by rejiggering your portfolio, including economic indicators that are often as clear as mud and the high trading and tax costs that may, in part, negate any potential gain from switching to safer investments.

But that's not all, Vanguard also warns of "the inconsistent performance of asset classes over time, the long delay between when recessions begin and when they are confirmed in economic statistics and the often-narrow trading window in which one has to act. Finally, defensive (read, reactive) investing comes with considerable and underappreciated cost -- not being strategically invested in the equity market when the bad times end."

At this point the market has lost 14.44 percent since July 22 if you look at the Wilshire 5000 Total Market Index, without a crystal ball it's difficult to ascertain exactly what will happen next and when it will happen.

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