Something must be in the financial water lately, as even the most bullish investors have started publicly expressing worry about the stock market finally reaching an unsustainable climax after more than a decade of record growth. With increased stock volatility, inverted yield curves, and global trade worries all making news, the economic tension is palpable to the point that the dreaded R-word is starting to get some significant buzz.
Are we headed for a recession?
Recessions get people worked up for a variety of reasons. For example, the events of 2008 decimated the stock market, cost scores of people their jobs, forced many leveraged buyers out of their homes, and nearly upended the entire financial system in the process. While there are many factors that contributed to that turmoil beyond the recession that came with it, it’s true that recessions tend to coincide with a lot of negative financial events. So it’s understandable that anyone who lived through the situation might be worried about a repeat and walking on eggshells given current market sentiment.
I’m not going to pretend that I have all of the answers for every problem associated with recessions, nor am I going to claim I have any idea when the next recession will start. But as a long-time student of portfolio history I’m in a pretty decent position to bring something to the table when it comes to how to structure your investments to weather the inevitable storm. So rather than just peddle in the typical doom and panic, let’s study something productive.
Which portfolios performed the best in recessions, and what can we learn from them?
Comparing portfolio returns in a recession
Studying recessions is actually a little tricker than you might think, as they’re usually relatively short and are difficult to isolate in a database of annual returns. Since 1970 there have been six recessions in the United States and the average duration was less than a year. Some were more painful than others, but two stand out as the worst of the bunch and are prime candidates for study. The first lasted from November 1973 to March of 1975 and the second was from December 2007 to June of 2009. So working with our available data, let’s look at the single full years wholly contained within each prolonged recession — 1974 and 2008.
For historical reference, in 1974 the US experienced the oil crisis and a major stock crash that led to a double-whammy of economic stagnation combined with skyrocketing inflation. It was an incredibly tough year for investors, and here’s how every portfolio on the site performed in inflation-adjusted terms.
As one might expect, stocks took a real beating. Even for well-diversified investors the average loss for all portfolios was 18%, so just any old asset allocation alone wasn’t enough to completely numb the pain. But look towards the right and there’s a really wild result in the mix. Even during one of the most turbulent recessions in the past 50 years, the Permanent Portfolio made money! If nothing else, this chart shows that when it comes to dealing with recessions not every portfolio is created equal.
Now I already know what some of you are thinking right now. The best three portfolios all contain gold, and the repeal of Bretton Woods was a one-time event that caused gold to sharply appreciate through 1974. And even beyond gold, it’s easy to imagine that some of the other global events that precipitated the recession might have also affected the rankings in ways that aren’t so obvious. Is this really a reasonable comparison for today’s investors?
That’s a great question and a fair point. So let’s fast-forward 34 years and look at the same comparison in 2008. By then the gold correction was ancient history and the 2008 recession was driven by completely different factors such as the subprime mortgage crisis and the resulting global financial meltdown from over-leveraged banking practices.
Now that’s interesting. 2008 was noticeably worse than 1974 for most portfolios, so the “Great Recession” moniker was well-earned. And some portfolios did change order a bit due to the specific economic conditions of their underlying assets. But at this point you might notice why I highlighted the best four portfolios on the first chart. Not only did the same four top the chart in 2008, but the gap between them and everything else grew even larger.
Beyond recessions: What’s the worst case scenario?
To make sure we’re not jumping to any conclusions, let’s do a quick sanity check. For all we know looking at the charts from the two major recession years, the best-performing portfolios might have done terribly in one of the other untested years. And while recessions may be short by strict definition, the impact on the overall economy can linger for years. So let’s cut to the chase and look not just at a single year, but map the deepest compound drawdown (using year-end data) for each individual portfolio over every start date we have access to.
The typical drawdown for all portfolios was a pretty brutal 30%. There’s no escaping it — that hurts. But the same four portfolios topped the list yet again. Some portfolios are simply more resistant to economic downturns than others, and it’s not just chance or an example of cherry-picked timeframes. There’s clearly something about their structure that makes them uniquely suited to the job.
The four portfolios that survive just about anything
To understand what’s going on, let’s look more closely at these asset allocations and see if we can identify any patterns. Note that I used asset acronyms to save space, but if you don’t know what they mean you can click on the image for more info.
- 15% SCV
- 7.5% Int’l SCV
- 7.5% EM
- 70% IT
- 30% TSM
- 40% LT
- 15% IT
- 7.5% COM
- 7.5% GLD
- 20% TSM
- 20% SCV
- 20% LT
- 20% ST
- 20% GLD
- 25% TSM
- 25% LT
- 25% BIL
- 25% GLD
The first thing that stands out is the general lack of international diversification, which is also a bit of a red flag. Investors in the United States are definitely spoiled, as the hot-burning historical record for domestic assets often skews portfolio backtests. To check that, let’s look at the same rankings for a polar-opposite market — Japan. While studying this chart, keep in mind that these Japanese portfolios do not simply translate US returns using Japanese inflation and exchange rates. They also interpret each portfolio through the lens of a Japanese investor who substitutes domestic Japanese stocks and bonds where American investors would normally buy the US variety. I like to do this to evaluate the underlying portfolio theory independent of a specific market, and under those circumstances it’s easy to assume that any portfolio heavily investing in the Japanese market over better international options was in for a rude awakening.
Surprised? While the worst-case drawdowns were deeper for all portfolios and I had to extend the chart for that terrifying 70% stock market drop, the same four portfolios topped the list. And believe it or not, these portfolios also rank as the top-4 for four of the six countries I track and are top-7 in the other two.
It’s no fluke. These four portfolios are just really good at protecting your money in all types of economic conditions.
What makes these portfolios special?
We’ve already seen that the secret to the recession-mitigating skills of these portfolios is not due to international diversification. It’s also not about diversifying stock factors like small and value or expanding into trendy smart beta strategies, as two of the four portfolios exclusively use good, old-fashioned total market stock funds. So what is so unique about these particular investing options?
Let’s look again at the individual asset allocations. I’m going to remove the asset details so we can focus on the structure. Red is domestic stocks, blue is international stocks, green is domestic bonds, and purple is real assets like gold and commodities.
While each portfolio is unique, they share a common thread of having notably low percentages of stocks compared to most modern recommendations. In fact, none of the top recession-proof portfolios contain more than 40% stocks. I think a big takeaway here is that while smart investors are wise to recognize that large cap US stocks may not always be the top choice in every economic environment, they tend to focus way too much on diversifying away from the domestic market or towards small and value while ignoring the big elephant in the room. The real risk-reducing move is to diversify away from stocks altogether.
But make no mistake, the success of these four portfolios is about way more than just adding bonds. The specific assets and percentages matter, and it’s not necessarily obvious because there’s a significant difference in underlying philosophy between these portfolios and the way many people think about how investing is supposed to work. You could put a fancy name on it like risk parity or modern portfolio theory, but it really just comes down to thinking in terms of balanced systems instead of individual components.
The old-school value investing mindset for building a portfolio is to evaluate each investment on its own merits and to collect a group of assets that you believe will all significantly grow. Of course, when the market as a whole craters your carefully curated basket of companies generally falls in tandem which is one reason why market crashes are so painful. What’s interesting is that these four portfolios share a very different mindset and prioritize two distinct risk management strategies that intelligently use investment uncertainty to their advantage.
First there’s the Permanent Portfolio and its younger Portfolio Charts spin-off the Golden Butterfly. Both are based on the work of Harry Browne who wrote extensively about designing a portfolio to work well in the four possible economic conditions — growth, recession, inflation, and deflation. That’s why they utilize bond barbells of long and short treasuries to handle different situations, and it’s also why they recommend gold to carry the day when stocks and bonds both fail to deliver. By diversifying based on every possible economic condition, they prepare your portfolio for whatever the future holds.
Larry Swedroe takes a slightly different approach. Rather than diversifying based on economic conditions, he balances the Larry Portfolio based on the mathematical volatility of each asset. By mixing small percentages of carefully selected risky stock classes with high percentages of comparatively safe bonds, the final portfolio equalizes the effects of each gyrating asset on the daily account balance. So even when the economy hits a major recession and one or more assets struggle, the overall portfolio is always prepared to safely wait out the downturn without worry.
While Ray Dalio speaks of portfolio construction largely in terms of economic diversification that echoes many of Harry Browne’s themes, I would argue the All-Seasons Portfolio is a mix of the two strategies. Look at the structure of the All-Seasons Portfolio through the lens of the Larry Portfolio with large percentages of bonds, the same percentage of stocks overall, and gold and commodities as volatile assets replacing Swedroe’s international options, and they could easily be portfolio cousins.
Long story short, the four portfolios most immune to recessions are specifically designed to balance the underlying assets based on internal volatility and/or external economic conditions. Anyone looking to protect their own portfolio should give strong consideration to similar risk management strategies.
How to apply these ideas to your own portfolio
We’ve talked about the data, we’ve covered the theory, and now comes the most important part. What can everyday investors do with this information?
First, I recommend a moment of thankfulness. Every investor is different and there’s no one portfolio suitable for all people, but luckily there’s more than one good recession-fighting portfolio. There are four! And with a few tweaks inspired by these four models your own portfolio can do just fine as well. So no matter whether you personally prefer the specific implementation of Swedroe, Dalio, Browne, that Tyler guy, or something of your own creation, the important core idea is this:
Build a well-rounded portfolio specifically designed to grow and protect your money no matter what happens in the larger economy, and you’ll never have to worry about a recession
It’s not about predicting the future. It’s about admitting you can’t and preparing for anything that might happen. While I can’t speak to the specifics of your personal situation, here are a few of those preparations I’d recommend for consideration based on the four portfolios we’ve talked about:
- Really think about cutting back on stocks to something less than 50%. Some people may laugh and tell you that’s way too conservative, but those same people will likely be freaking out and complaining about their losses when the next stock market correction inevitably comes. Stocks are just one asset in the grand scheme of things, not the entire “market”. Betting most of your money on economic prosperity is exactly how most portfolios get killed in a recession.
- For bonds, your choice depends on your preferred portfolio approach. If you’re taking risks on niche stock classes like Swedroe, stick to larger quantities of shorter maturities with your bonds. But if you’re looking to balance your portfolio based on economic conditions like Browne, give long term treasuries a try as the added volatility helps these portfolios react to economic conditions.
- Three of the four portfolios find gold to be an effective ingredient to mitigate downside risk. It seems very counter-intuitive that a shiny metal with no yield can maintain or even increase portfolio returns while reducing volatility, but play around with the calculators and you’ll see it doesn’t take much to have a noticeable positive effect. And as we’ve seen, it’s not simply an artifact of a one-time gold correction. Gold adds valuable diversification in a well-balanced portfolio and has historically responded strongly when it’s needed most.
Risk, reward, and smart portfolio strategy
While you’re thinking about risk management, I find it’s also inspiring to keep an eye on the reward. Here’s the amazing thing that catches lots of people by surprise. Contrary to your academic instinct that usually equates risk and return with very little tangible understanding of the uncertainty involved, portfolios that avoid recessions and don’t need to recover from major drawdowns also consistently provide desirable long-term compound returns. For example, here’s a Risk and Return chart mapping the deepest drawdown and 15-year baseline return for every portfolio on the site. The most efficient grouping on the left should look familiar by now.
Are you worried about a recession decimating your portfolio and delaying or canceling your important life goals? The best time to prepare for a market downturn is before it happens, so there’s no better day than today to get started. And don’t take my word for it. Read the books authored and inspired by Swedroe, Dalio, and Browne and you’ll learn more about portfolio construction than I could ever hope to describe in a single post. Combine that theory with comprehensive portfolio history to validate ideas with real-world results, and you can absolutely learn how to protect your hard-earned savings so that you can invest with confidence.
Recessions have happened many times before and will happen again. Are you ready for the next one? No matter how you ultimately choose to invest, the top four recession-proof portfolios have a lot to teach you if you’re willing to learn. So turn off the news, start reading, and enjoy the financial and emotional benefits of smart financial planning.
You’ve got this.
Did this inspire you to recession-proof your own portfolio?