A levered investment in the S&P 500, with the leverage chosen to achieve a beta of 1.5, would have outperformed the index itself by 150 basis points annually over the 1928–83 period. Unfortunately, the risk incurred by such a strategy is generally unacceptable to even aggressive investors. There is a strategy, however, that will provide good upside participation while limiting downside exposure.

A Dynamic Asset Allocation (DAA) program involves shifting a portfolio’s mix between a risky asset and a safe asset, so that the portfolio’s expected return will fall between the expected returns on the two assets. The investor can specify any minimum return that does not exceed the return on the safe asset; the higher the minimum return, the lower the proportion of the portfolio allocated to the risky asset, and vice versa. The key to a DAA program is changing the allocations as the risky asset’s behavior changes. If the risky asset is the S&P 500, the risky position would be increased whenever the index moved up and decreased whenever the index moved down. Expected returns may be increased by levering the position in the risky asset through borrowing.

Historical simulations indicate that a DAA strategy using the levered S&P 500 and the one-year Treasury bill and with a specified minimum return of –15 per cent per year would have beaten the S&P 500 in 58.9 per cent of the years from 1928 through 1983 and achieved a compound annual return of 10.4 per cent, versus 9.1 per cent for the unlevered S&P 500.