With the presidential election now over, it’s time for investors to consider what the looming fiscal cliff could mean for asset allocation in 2013. While no one can predict the future, I don’t expect next year to be characterized by a “normal” investing environment that is well suited for a typical strategic allocation strategy.

Instead, 2013 offers two very distinct scenarios. First, there is the possibility of a fiscal cliff-induced recession. Second, there is the possibility of continuing gains in equities if the cliff is avoided and the US economy continues on its recovery path.

How should an investor approach asset allocation given the uncertain outlook? I’d recommend taking into account the different *probabilities* of 2013 experiencing a cliff-induced recession.

To do that, let’s construct a portfolio that is a mix of stocks and bonds to be held over the next year. Then, let’s look at the range of possible return outcomes if next year turns out to be a “typical year”. I have taken monthly return data (in excess of the 30-day government yield) for the U.S. stock market and the U.S. bond market since 1926[1], and I’ve computed the 12-month returns of simple bond/stock portfolios for all possible 12-month periods since 1926. The results are summarized in the three lines in this chart: the typical return, the potential upside return (defined as 75^{th} percentile of return outcomes) and the potential downside return (defined as the 25^{th} percentile of return outcomes):

The horizontal axis shows the percentage allocated to bonds and the vertical axis shows the typical 1-year returns of these portfolios over the last 85 years. The chart confirms what could be considered standard intuition: Taking a higher allocation in equities produces higher returns, as shown by the median return line. But it also produces a wider range of returns, as indicated by the 25th and 75th percentile lines, which is reflective of the increased risk that a higher allocation to equities produces.

Now, what would happen if the United States went over the cliff in 2013, creating negative economic growth through part of the year? To answer that, let’s look at what happens to the returns of a typical portfolio that experiences an economic contraction in the year after the simple bond/stock portfolio has been constructed[2]. Data from the1926-2012 period shows that if a portfolio is constructed at the end of a month that is not already classified as an economic contraction then the probability that there will be at least one quarter of negative growth over the following 12 months is about 15%. In other words, investors who think that the probability of a fiscal cliff-induced economic contraction in 2013 is the same as the “normal” 15% probability of contraction can use the chart above as a guide for simple allocation.

What about investors who think the probability of a cliff-induced recession is higher than normal? The chart below shows what happens if the probability of a cliff-induced economic contraction is set at 50% instead of 15%[3], as Russ Koesterich has argued recently.

The chart suggests that even for aggressive investors there is little reason to have a large allocation to equities if you believe there is a higher-than-normal chance of a recession. The chart shows that holding more equities would not be expected produce returns that are materially better than a conservative allocation. In addition, the size of the potential downside also increases across the board – in other words, an investor is not likely to be rewarded for taking on additional risk.

The upshot of this analysis? Investors do *not* need to have high conviction that cliff-induced recession will take place next year to consider some reallocation in their portfolios. History suggests that an even 50/50 chance of recession in the next 12-month (compared to the 15% normal chance) can have a material impact on the typical 1-year returns associated with a simple bond/equities allocation. As we have argued in the past investors concerned about heightened volatility on the back of longer-term macroeconomic concerns — including a cliff-induced recession — should consider some reallocation toward dividend-paying equities as well as managed volatility portfolios.

*[1] Stock return data is from Fama-French, reflective of the return of the total U.S. stock market as commonly used in academic research. The 30-day government rate (or “risk free” rate) is also from Fama-French. Return data for bonds is from the IA SSBI database, computed as a combination of corporate bond total returns (weighted at 33%) and intermediate government bond returns (weighted at 64%). [2] I used the standard NBER classification of U.S. economic cycles to classify every month in the 1926-2012 period as either in contraction or expansion. [3] This chart is constructed in the same way as the first chart, except that periods of economic contraction (i.e. 1 year periods with at least 3 months classified as contraction) are weighted so as to account for a 50/50 chance of occurrence.*

*Daniel Morillo, PhD, is the iShares Head of Investment Research*.