So is it the time to go "defensive" with your portfolio?

A research paper released recently by Vanguard's Investment Strategy Group has
analysed returns for a balanced portfolio going back to 1926.

Co-authored by Vanguard chief economist Joe Davis and Daniel Piquet the research
study - Recessions and balanced portfolio returns - set out to test the
conventional wisdom that, faced with the prospect of a recession, investors may
wonder whether to shift their portfolios to more "defensive" settings to
minimise losses.

The study calculated returns on a hypothetical portfolio invested 50 percent in
US shares and 50 percent in bonds under two distinct US business cycle regimes -
recessions and expansions. The recessions and expansion periods were those
officially defined by the US National Bureau of Economic Research.

The average annualised returns - both nominal and inflation-adjusted - were
calculated for the balanced portfolio using monthly data from 1926 to June
2009.

There is a clear implication for conventional thinking coming out of the
analysis.

This is because the average returns on a balanced portfolio over that span have
been "similar regardless of whether the US economy was in or out of
recession".

This was particularly true of the inflation-adjusted returns because inflation
tends to be higher during periods of stronger economic growth.

Indeed the average real return (i.e. adjusted for inflation) between 1926 and
2009 through was 5.26 percent during times of recession in the US compared to
5.59 percent return for periods of expansion.

That said, while the average returns since 1926 have been similar regardless of
business cycle the returns for shares, bonds and the balanced portfolio have
varied between specific recessions.

The average return results are clearly counterintuitive but the research
suggests the similarity in average real returns occurs because of two
often-complementary forces at work in a balanced portfolio.

When the likelihood of a recession is rising or imminent there is a tendency
for bonds to outperform stocks during the initial period of weakness - the
so-called "flight to safety" effect.

Secondly, share prices tend to decline before a recession officially begins and
to rise before the recession is officially ended - the sharemarket being in effect
a "leading" indicator.

As the research highlights, that should not be surprising because since 1926,
10 of the 20 highest returning months on the US
sharemarket have been during recessions and 7 of the top 10 performing months
have been when the US
economy has been in recession.

Past performance is just that. So the average historical return of a balanced
portfolio during past recessions should not imply that if the US slips into
recession later this year you should expect similar returns. Other measures
like current sharemarket valuations and bond yields need to be considered as
well.

It is understandable that investors may feel tempted to take defensive action
because of concerns about the possibility of a US recession.

What this study points to is the higher-level need for investors to have an
asset allocation that matches their risk tolerance and long-term objectives.

And while a 50/50 portfolio will not be appropriate for every investor it does
illustrate how taking a balanced, well diversified approach has weathered past
periods of recession.

It also points to the many obstacles investors face in trying to time defensive
investing moves because even the best signals of bear markets are low when it
comes to predicting future returns.

Finally, attempting to time market moves comes with the hidden or perhaps
underappreciated risk of being out of the equity market when the bad times end.

By Robin Bowerman
Smart Investing
Principal & Head of Retail, Vanguard Investments Australia

9th December 2011