How One Mediocre Investor Prospered After the Market Crash

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The mediocre financial advice I've offered in my last few posts boils down to this: Use low-cost funds, establish an appropriate asset allocation, and rebalance it annually.

It's not new advice. My own portfolio was strongly influenced by it back in the early 1980s. By the 1990s, it was pretty much the standard advice you would get anywhere. Many studies at the time showed that a very simple portfolio — just an S&P 500 index fund, plus a long-term bond fund — tended to outperform managed funds, especially after the costs of the managed funds were taken into account.

I haven't seen as many studies in the years since the financial crisis, so I thought I'd take a quick look at how this sort of basic asset allocation held up in the aftermath.

Most people date the financial crisis from 2008, but I tend to date it from June of 2007, because that's when I found out that I'd be losing my job. For that reason, the graphs below run from then through the latest data available as of March 29, 2017.

As it turns out, a mediocre portfolio held up pretty well.

Criteria for success

To decide whether a particular style of investing is a success, it helps to know what your goals are. Most people would include "maximum return" as at least part of their goal, but instead, I suggest that your portfolio provide an investment return that supports your specific life needs.

A portfolio that comfortably beats inflation is part of that. It's also a plus if the portfolio doesn't swing wildly in value — in case your circumstances require you to cash out a significant amount on an emergency basis. It's nice, too, if the portfolio provides a mix of income and growth, so that if changes in what's in fashion among investors push one category of stocks up or down, the overall value of your portfolio doesn't take too big of a hit. (Personally I've always had a sneaking preference for income, even though tax policy has often favored growth.)

With those criteria in mind, let's look at how some of the pieces of a mediocre portfolio have done.

Pieces of a mediocre portfolio

The most basic mediocre portfolio is just an S&P 500 index fund and a long-term bond fund, with the ratio between those two gradually shifting from mostly stocks (for a young person) toward mostly bonds (for someone who has already retired).

Stock market investments

The value of an S&P 500 index fund dropped dramatically during the crisis itself, but it hit bottom well before the end of the recession, recovered all of its losses by 2013, and is now about 50 percent above where it started — meaning that on stock price alone, you've got an annual return of well over 4 percent. With dividends reinvested, your annual return comes to nearly 7 percent (take a look at the 10-year average annual return of your favorite S&P 500 index fund).

(Source: St. Louis Federal Reserve)

Bond market investments

There isn't an exact bond-market equivalent for the S&P 500 index fund, so it's a little hard to say how your investments would have done during the crisis and since. (I poked around at a few major mutual fund companies and found average annual total returns on various long-term bond funds for the past 10 years ranging from 3.6 percent to 6.1 percent, depending on the fund.)

The return on a bond fund depends on interest rates. If you buy a bond that pays X percent and rates go up, your old bond is worth less (because otherwise people will just buy the new bond that pays more). Conversely, if rates go down, your old bond is worth more.

With that in mind, here's a graph of the interest rate paid on a U.S. government 10-year treasury bond:

(Source: St. Louis Federal Reserve.)

Long-term interest rates dropped steadily before and during the recession. They rebounded modestly as the recession wound down, but then plummeted as it became clear that the economy needed, and would continue to need, extraordinary support from the Federal Reserve. Even now, long-term rates are about half what they were before the crisis began.

The upshot is that the value of bonds purchased before the crisis would have soared during the crisis. Bonds purchased during the crisis would also have gone up. Bonds purchased in the aftermath might be up or might be down, depending on exactly when they were bought.

Rebalancing

If you'd just had a portfolio of stocks or bonds, you'd have done ok. Your stocks would have gone down a lot, but they'd have eventually recovered. Your bonds would have gone up a lot, and would have since eased off. But the mediocre asset allocation is more than that. The essence of a mediocre asset allocation is annual rebalancing.

At the end of 2007, and again at the end of 2008, you would have sold some of your bonds — which would have jumped a great deal as interest rates fell ahead of and during the recession — and shifted that money into depressed stocks to restore your asset allocation.

New stocks purchased on the last day of 2008 would have been bought with the S&P 500 at 891 (down from close to 1,500 when you started). At the recent price of 2,359, those shares are up 165 percent. At the same time, you would have harvested much of the gains in your bond portfolio.

Really, the rebalancing is where the magic is.

Success

As I mentioned at the beginning, the criteria I'm using as indicators of success are return, stability, and providing a mix of income and growth.

The mediocre portfolio did a fine job of providing a return — especially if you rebalanced annually, thereby automatically buying stocks when they were at their lows.

Stability is always a problematic goal, because it's almost the opposite of growth — the most stable portfolio would be one invested 100 percent in cash, which would show no growth at all. The point here, just as it is with return, is not maximum stability, but rather a degree of stability that supports your life goals. Here again, the mediocre portfolio did fine, especially for older people with a larger bond portfolio, which is where it is most important.

Finally, the mediocre portfolio did a fine job at balancing income with growth. An S&P 500 index fund has produced a pretty good yield, especially compared to cash and bonds during this period of historic lows in interest rates. Annual rebalancing will have automatically shifted money out of bonds as interest rates fell (reducing the fraction of the portfolio invested where income is low) and future rebalancing will be shifting money back into bonds as interest rates rise.

I would hesitate to call its performance better than mediocre, but that's really the point: A mediocre investment portfolio, providing mediocre performance, is all it takes to support your life goals.