Tuesday, May 11, 1999

The Couch Potato Portfolio has arrived.

It has been discovered in New York.

In recent research on efficient asset allocation strategies, Neuberger and Berman LLC, a New York-based investment management firm, found that a 50/50 or 60/40 combination of stock and 1-month or 5 year Treasuries offered "the optimum return/volatility trade-off."

What that means, in English, is that you can get most of the return of common stocks with less of the risk by adding some fixed income securities to your portfolio. We Couch Potatoes, of course, have known this for a long time.

But now we can say "Its Official."

Heres what Neuberger and Berman did. They used the S&P 500 Index as a measure of stock market returns and tested different terms of U.S. Treasury securities in three different proportions. Specifically, they tested 1-month, 5 year, and 30 year Treasuries in portfolios that were 50/50, 60/40, and 70/30 mixes of equity/fixed income. They calculated the return and volatility (price variation) of each portfolio from 1960 to the end of 1998. The chart below shows the performance of each portfolio compared to the 12.03 percent compound annual rate of return of the Standard and Poors 500 Index and its 14.79 percent price volatility.

The Return/Volatility Trade-off

Stock/Debt 1 month Treasury 30 year Treasury
Actual (% S&P 500) Actual (% S&P 500)
50/50 Return

Volatility

9.19% (76%)

7.36% (50%)

9.87% (82%)

10.42% (70%)

60/40 Return

Volatility

9.81% (82%)

8.83% (60%)

10.35% (86%)

10.99% (74%)

70/30 Return

Volatility

10.40% (86%)

10.32% (70%)

10.81% (90%)

11.75% (79%)

Source: Neuberger and Berman, LLC

Among their significant findings:

  • Whatever the portfolio mix, there is no improvement in return when you use 30 year bonds instead of 5 year notes— but there is a significant increase in risk.
  • That you can get 90 percent of the return of the S&P 500 Index in a portfolio that is 70 percent Index and 30 percent 5 year Treasury notes. The risk, however, will be only 74 percent as great as the all-stock portfolio. Similarly, you can get 86 percent of the return of an all-stock portfolio with only two-thirds of the risk in a 60/40-portfolio mix.

Now lets take the study a step further and compare the returns of managed domestic equity funds with the S&P 500 Index. Over the last 15 years (ending March 31) the S&P 500 Index has provided an annual compound return of 18.47 percent. The average domestic equity fund, excluding any adjustment for those with front-end loads, has provided a return of 14.33 percent, according to Morningstar, the Chicago publisher of mutual fund data. Thats only 78 percent of the index return.

So take a look at that center column again. Whether you mix an index investment 50/50, 60/40, or 70/30 with a 5 year Treasury, the evidence shows that you would have enjoyed a greater return, with less risk, than the average managed equity fund.

Managed fund defenders will immediately tell us that the last 15 years are different because there has been a stampede into the large capitalization stocks in the index.

Thats true. But the conclusion holds if you take a longer view. From 1960 to 1998 the S&P 500 Index provided a compound return of 12.0 percent. During that period, the average managed equity fund had an expense ratio of about 1.4- percent. Expenses have regularly absorbed a bit more than 10 percent of gross returns.

The bottom line: over a long period of time, an index portfolio that is somewhere between 50/50 and 75/25 equities/fixed income will do as well as a portfolio that is 100 percent invested in the average managed equity funds.

And it will do it with less risk.

Some portfolios aspire to greatness; others— like the Couch Potato— have it thrust upon them.

Note to Readers: The 14th Annual "Evening with Scott Burns" will be held tonight, Tuesday night, May 11th in the Stemmons Auditorium in the Wyndham Anatole Hotel, 2201 Stemmons Freeway. Reception at 6:30, Event at 7:00. Suggested contribution, $10 for the Communities Foundation of Texas. For more information call 214-826-5231