Investing in the stock market these days is akin to jogging on the rim of the Grand Canyon: there's little margin for error and the downside view is spectacular! While surfing out the waves of this seven-year bull market many investors are looking for ways to play a little closer to the shore. Last year at this time a series of Tsunami waves hit the Asian stock markets from which investors in Asia have yet to recover. Now the North American market waters are increasingly turbulent. This morning in fact, the Dow Jones was down 171 points (Tuesday, August 11, 1998), but where it will end the day no one knows.

The following chart shows the performance of three different types of investments (asset classes) over the period. All three have been made into indexes starting at 100 at the end of 1928 and then graphed year by year according to their performance. For instance, if you invested $100 in long-term US Treasury Bonds January 1, 1929 and reinvested all of the interest, by the end of 1938 your $100 would have grown to $181.94. All the rates of return were calculated after adjustments for inflation/deflation and commissions on reinvested amounts but no taxes were deducted.

Notice that the NYSE, which is an indicator of average stock performance, fell to 40% of its 1928 value by 1931 and only really recovered to its 1928 level by the end of the period. Bonds and T-Bills (very short-term bonds) grew at about the same rate until 1934 when bonds pulled ahead. Again note that the growth in value depicted has been adjusted for changes in the price level. The early 1930s were deflationary so the value of a dollar was increasing in terms of what you could buy with it.

We can conclude from figure 1 that if you were to buy just one type of asset and had had 20/20 hindsight; you would have put all your money in bonds for the 10-year period and thereby outperformed all the other investments. Long-term US government bonds had a compound rate of return of 6.11%. But most investors don't put all their eggs in one asset class because, among other things, there are plenty of periods in history that were less kind to bonds.

Since most investors wisely divide their holdings into portfolios including different types of assets, the real question becomes, how to manage ones portfolio and how to allocate ones capital between the different types of assets. Here we proceed to examine how three popular portfolio strategies: Buy and Hold, Passive Asset Allocation, and Dollar Cost Averaging, performed in the deflationary Great Depression environment.

Notice that the passive asset allocation strategy performed worse for all three allocations when the stock market was falling but recovered more quickly when the stock market began to rise. By the end of the depression all three passive allocation portfolios were slightly ahead of the buy and hold portfolios. If you factor in the tax and commission costs associated with shifting capital around, the two strategies are probably very close. In both cases however the larger the bond investment the better the performance. The compound rate of return on the best case scenario was 5.8% in this case.

As you can see, dollar cost averaging into stocks produced the best long-term results of all the investment strategies that we have considered. The compound annual growth rate was 6.11%. Dollar cost averaging into bonds also performed well and with more stability.

The best conclusion to be reached is perhaps the renewed respect for the balanced portfolio and the important place of long-term bonds and T-bills or money market funds in it. The Great Depression was a uniquely severe period of time and is unlikely to be repeated in exactly the same way at least. One would like to think that we learned enough to avoid repeating it. However, as long as there is hype there is bound to be disappointment. And in the face of the spectacular returns on stocks of late is hard to put half the portfolio in boring old bonds even though it may be prudent. Long-term US Treasury bonds are yielding between 5 and 6% these days. Another conclusion that could be reached is that if you're worried about a market correction but sitting on top of a pile of cash to invest, the way to proceed is with dollar cost averaging.

It would be a mistake to conclude from the above that the ideal investment portfolio is one with 80% invested in bonds. That may be true for someone anticipating a repeat of the Great Depression over the next ten years, but even then factoring in tax rates would reduce bonds' appeal slightly.

It's probably true that many people are far more aggressively exposed to stocks and bonds than they should be. It is easy to over-invest in a period following the spectacular returns we have seen. There are many periods in history over which stocks under-performed dramatically but that has also been true of bonds. It goes without saying that personal debts should take priority over stock investing. Home equity loans and unsecured debts are the stuff of which depressions are made.

 Layth Matthews

All statistics used in this article were taken from A Half Century of Returns on Stocks and Bonds by Lawrence Fisher and James Lorie. A book published by the University of Chicago Graduate School of Business in 1977.