A simple 50/50 Asset Allocation Model is based on a passive two-asset class portfolio. It was built to reduce volatility of returns, decrease risk, and provide relatively stable performance in comparison to the S&P 500 Index alone. This model is created by investing 50% of assets in the exchange traded fund (ETF) linked to the S&P 500 Index, and the remaining 50% of assets invested in another ETF linked to a long-term US Government Bond Index with maturity of 20 years or longer. Using back testing, this allocation was proven to decrease volatility and produce stable returns during 2003-2012 time periods. The main difference between this Simple 50/50 Asset Allocation Model and other similar 50/50 bond/equity allocations is that the model described in this paper is based on a long-term US government debt.

Recent global financial crisis has changed the behavior of returns for corporate bonds and the US equity. Many long-term investors believe in a strategic asset allocation, which includes a combination of fixed income and equity. Historically, these distinctively different asset classes provided good diversification. However, during the financial crisis of 2008, the correlation between the returns of corporate bonds and equity increased causing the diversification benefits of a typical 50/50 equity-bond portfolio to decline. For example, iBoxx $ Investment Grade Index has returned only 0.96% in 2008 according to iShares (2012, October 7). At the same time, SPDR S&P 500 ETF, ticker SPY, has lost 36.80% (see table 1 below). Such poor performance during the financial crisis has diminished the diversification benefit of a typical equity/corporate bond asset allocation model. The timing of this paper is important because the Simple 50/50 Asset Allocation Model looks into structural changes; increase in correlation between corporate bonds and equities; and provides strategic asset allocation with diversification benefits that remain intact during a severe financial crisis; such as, the financial crisis of 2008.

Combining the performance of S&P 500 Index with the performance of long-term US Government Debt, the Simple 50/50 Asset Allocation Model can decrease volatility/risk, and should provide stable performance over time. These two attributes are very important for most investors as they solve an essential task of market timing. It should not matter when the investment is made using the Simple 50/50 Asset Allocation Model. The dynamic risk management characteristics of the model automatically increase risk exposure during good market conditions and decrease risk exposure during bad market conditions. The correlation between the returns of the US equities and the US government bonds increases when economy is doing well and decreases when economy is doing poor. As the result, the investor is not burdened by the task of market timing and forecasting the near-term future.

The fundamental principles of investing half of the assets in bonds and half in equities have been tested by time and advocated by renowned investors. This model is consistent with ideas of Benjamin Graham and John C. Bogle. Benjamin Graham has described 50-50 division as a simple model, which is appropriate for a conservative investor and provides both upside in a bullish market environment and better performance vs. more aggressive investors in a bearish market environment according to Benjamin Graham (2003).  According to John C. Bogle (2011, April 27), founder of the Vanguard Group, investing 50% of assets in equities and 50% in bonds is a better asset allocation than many other models out there.

The model in this article is somewhat different from what Benjamin Graham and John C. Bogle advocated as its 50% bond exposure is based solely on long-term US government debt. In this paper, the Simple 50/50 Asset Allocation Model is specifically based on two securities: SPDR S&P 500 ETF, ticker SPY, and iShares Barclays 20 Year Treasury, ticker TLT. In order to make a Simple 50/50 Asset Allocation Model even easier to implement than to understand, we invest 50% of money in SPY, and 50% in TLT. The historical back test and the entire analysis below are based on these two ETFs.

Dynamic Risk Management

Keeping the asset allocation steady over time, the model has unique ability to reduce risk during a recession and increase risk during an expansion on its own. Risk exposure of the Simple 50/50 Asset Allocation Model changes dynamically based on a particular stage of a business cycle. The correlation of price movements between government bonds and corporate stocks increases during good times and decreases during bad times. For example, during a bullish stock market performance in 2003-2006, the daily correlation of price changes between SPY and TLT was increasingly positive. This correlation increased from 0.04 in the year 2003 to 0.67 in the year 2006 (see the chart #1). In contrast, just prior to the financial crisis, this correlation started to decline from 0.67 in the year 2006 to 0.02 in the year 2007 and to -0.71 in the year 2008. Interestingly, the risk off adjustment took place just prior to the stock market decline of 36.80%. The Simple 50/50 Asset Allocation Model demonstrated unique ability to hedge a downside risk by reducing the correlation between TLT and SPY price movements prior to the financial crisis.

Correlation is calculated based on daily adjusted close price changes for SPY and TLT. Performance for SPY is also based on adjusted close prices. Data is provided by Yahoo! Finance.

By holding 50% of assets invested in the long-term US Government Bonds, the Simple 50/50 Asset Allocation Model can provide a hedge against a stock market decline; such as, the financial crisis of 2008-2009. During a recession, long-term US government bonds can benefit from the decrease in interest rates, deteriorating corporate credit ratings, and increase in demand by investors. The reasons that the Simple 50/50 Asset Allocation model is based on long-term government bonds are that they have a greater duration and greater interest rate sensitivity necessary to move bond prices significantly enough to offset a decline in stock prices during an economic recession. By investing the remaining 50% of the portfolio in a broad market index, the model should provide growth and cover possible fixed income losses during an economic recovery and growth.

The dynamic risk management characteristics of the model are somewhat similar to a tactical asset allocation where investor makes changes to the portfolio based on short-term economic outlook. During an early stage of economic recovery, the Simple 50/50 Asset Allocation Model switches to a risk off mode: increase in correlation between SPY and TLT daily price movements. There are no changes in the federal funds target rate expected and investors continue to earn a positive return on a fixed income part of the portfolio as well as on the equity portion. In contrast, during the economic cycle when economy starts to slow, the model switches back to a risk on mode: the correlation between SPY and TLT daily price movements decreases. During this time, the Federal Reserve Bank (the Fed) is likely to pursue more expansionary monetary policies and decrease interest rates and/or buy government bonds. These policies will provide positive returns on long-term government bonds’ holdings, and partially or fully offset the decrease in stock prices. The Simple 50/50 Asset Allocation Model has an embedded natural risk hedge which decreases the price correlation of SPY and TLT and lowers the standard deviation for the model during bad economic times.

Risk of the Simple 50/50 Asset Allocation Model, as measured by the standard deviation of annual returns, is much lower than the risk of the SPDR S&P 500 ETF (SPY) and iShares Barclays 20 Year Treasury ETF (TLT) alone.