HISTORICAL PERFORMANCE: WHAT YOU WILL SEE

Three pages follow, one for each of the three example target allocations discussed a couple of pages back. The secular bull and bear markets do not correspond exactly to complete calendar years. However, the graphs and returns shown will be by year to avoid the distraction of deciding precisely when one type of market ends and the other begins. Also, retirement investing should be viewed as a long-term proposition, and looking at results for periods of less than a year can distract from getting the larger overall view.

Testing has been done for the 45 year period 1963-2007. Graphs will be shown corresponding to the last complete secular bear market (1966-81), the last secular bull market (1982-99), and the secular bear market currently in progress (2000-07).

As discussed previously, the porfolios for the sake of avoiding undue complexity consist of only three investment instruments: stocks, bonds, and money market. Most investors will likely want additional investment classes, but those three are sufficient to achieve financial goals. They are all you really need although not necessarily all you want to include.

For the purposes of testing, the three instruments are:

• Stocks: Total return (dividends reinvested) of the S&P 500 index. That index, which consists of large capitalization stocks that total about 75-80% of the value of the U.S. stock market, is considered a good measure of the broad market. Low cost index mutual funds such as the Vanguard Index 500 fund and the exchange traded "spiders" essentially match the S&P 500 total return.
• Bonds: As best I can tell there is no bond mutual fund or comparable index that dates back to the early 1960s. The "constant maturity" yields of treasury bonds are available that far back. Those were used in conjunction with standard interest rate to bond price formulas to generate a hypothetical mutual fund consisting solely of the 10-year treasury bond. Its returns in recent times are consistent with real bond mutual funds. However, it is more volatile since it consists of essentially only one security while a real mutual fund, even if it owns only treasury bonds, will have ones of differing maturities. The fund managers doing their jobs properly likely can anticipate interest rate trends and adjust the funds' holdings to reduce the volatility of the fund. Nonetheless, the hypothetical 10-year T-bond fund is a reasonable instrument to use for historical testing and evaluation of investment methods.
• Money market: The yield of the 90-day T-Bill less 0.25% is used. Low cost money market funds generally have yields in this range.

Returns and risk measures are shown for three investment approaches:

1. Unmanaged: This is essentially buy and hold. The target allocation percentages of each asset class are initially purchased. Rebalancing is performed at the end of any calendar quarter when the percent of the portfolio in any asset class differs from its target by 3% or more. There is nothing special about quarterly rebalancing or the 3% difference trigger, but those are reasonable.
2. Basic model application: Two risk reduction models, one for stocks and one for bonds, are applied to the target allocations for those asset classes. When the model indicates that the risks of owning the asset class are too high, the portion of the portflio for that asset class will be in money market instead. Rebalancing as described above is also performed, but this is infrequent because the movement in and out of the money market fund--two or three times a year is typical--usually takes care of keeping the portfolio close to the target allocations.
3. Aggressive model application: If one of the models indicates that its asset class should not be owned while the other model says that its class should be in the portfolio, then the portion allocated to the class with the negative model reading will instead be in the asset class with the positive model instead of being in the money market fund as would be the case with the basic application of the models. For example, suppose the model for stocks says they should not be owned and the model for bonds indicates that they should be owned. Then the funds allocated to stocks will be used to buy bonds, or more likely a bond mutual fund, instead. In the case of allocations that do not include money market in the targets, this can result in having the entire portfolio in stocks or entirely in bonds. As above, rebalancing will be done quarterly although it will be infrequent.