2011
A Brief History of Stock & Bond
Investment Risk and Return
Investment returns over the long-term have displayed a fairly consistent pattern of risk and return. As one might anticipate, over the long–term an investor has been generally rewarded with higher returns for taking more risk. The chart below shows the best single year return (light blue bar), the worst single year return (dark blue bar) and the compound annual growth rate (diamond in the middle) by asset class from 1926 until 2010. Risk decreases as you look from left to right on the chart, with small company stocks showing the largest range of possible yearly returns on the left side of the chart, and intermediate term U. S. Government bonds showing the smallest range of possible yearly returns on the right side of the chart. In short, over the long-term an investor should expect to achieve a higher rate of return from taking on more risk. The difference in the compound rate of return for the 2 extremes being 6.7 percent, per year between small company stocks and short-tern U.S. Bonds (12.1% minus 5.4% = 6.7%).
For each asset class, this 84 year period includes many rising ("bull") markets and many falling ("bear") markets. Major systemic shocks are reflected over this long period including the Great Depression, the inflationary 1970's, the long bull market from the early 1980's until the "dot com" bubble implosion in 2000, and the most recent decline in both stock markets and economic activity from November 2007 until the end of 2009. Wars, political turmoil, terrorism, earthquakes, floods and hurricanes are all reflected in these cumulative numbers. Of course, the recovery from the Depression, economic expansion, victory in World War II, the collapse of communism, the rise of the global economy and unprecedented productivity improvements from the micro-processer is also reflected by this chart. So, looking at investment returns over the over the long-term three conclusions can be drawn:
- Bonds produce lower rates of return with less risk.
- Stocks produce higher rates of return with greater risk.
- Higher returns can be achieved by taking higher risk.
But what about the short–term?
While the long-term view presented above tells you something about what the next 20 or 30 years might look like, it tells you absolutely nothing about the next 5-10 years. Both stock and bond markets have experienced long periods of returns substantially less than shown above. Markets have also experienced long periods of returns substantially greater than show on the above chart. The chart below, showing returns over the past 11 years, illustrates how returns can vary from long-term compound averages.
Over the eleven years ending in 2010, stock markets have produced slightly positive to negative returns. The S&P 500 Index comprised of large company stocks rose just over 4%, and the technology heavy NASDAQ Index declined almost 35% during this period. The other end of the spectrum of risk is shown by the green line which shows the positive 79 return for 1 to 10 year U. S. Treasury Notes. During this timeframe, stocks provided returns substantially lower (negative in some cases) than long term compound rates. Bonds provided significant security and returns greater than the long term compound average. The blue line on the chart represents a blended index of 60% stocks (S&P 500), and 40% bonds and cash. Not surprisingly, the returns for this index fall between the extremes of stocks and bonds. So, looking at investment returns over this shorter period three conclusions can be drawn:
- Stocks can underperform for significant periods of time.
- High quality bonds can provide security and return during uncertain times.
- A portfolio that blends stocks and high quality bonds can avoid potentially disastrous returns of an all stock portfolio.
So, what is the right mix of stocks and bonds – or asset allocation?
An appropriate asset allocation for a portfolio of stocks and bonds has often been viewed as a function of the age of the investor. Investors are often advised to take more risk at a younger age and less risk as they grow older. A traditional rule of thumb was 100 minus your age. Thus the allocation for a 20 year old would be 80% stocks and 20% bonds, and an allocation for an 80 year old would be 20% stocks and 80% bonds. The thinking being that as one gets older the time to recover from investment set-backs decreases and the need for security and stability rises.
However, how much risk a person takes in their investments should be much more a function of their personal tolerance for risk than their chronological age. If you look at your investment portfolio and think, "I've worked hard (or inherited from someone who worked hard) for this money, and I can't stand the thought of the value declining by a substantial amount", then you should not have an all stock portfolio. But, you should not ignore the first 3 conclusions discovered above – taking some risk has the potential to provide a significantly higher rate of return for your investments. Thus, most investors search for a mix of stocks and bonds that suits their tolerance for risk and volatility. The chart on the next page highlights how adding high quality bonds to an all stock portfolio (represented by the S&P 500) decreases return, but also decreases the volatility of returns.
Obviously, deciding how much risk to take in an investment portfolio is an individual decision. However, looking at the chart at the top of the next page, it is easy to see why many pension plans, foundations and institutions, end up with an allocation of roughly 60% stocks and 40% bonds and cash.
A 60/40 blend of stocks and bonds – over the long-term – will likely produce roughly 80% of the return of an all stock portfolio with about a third less downside risk. A 60/40 allocation is a reasonable person's trade-off between risk and return in traditional stock and bond investment portfolio. In general terms, such an allocation will allow an investor to participate in the good times and provide a level of protection in more difficult times. But a 60/40 allocation is not necessarily the default answer for everyone. There are many other considerations when deciding on an asset allocation including taxes, income needs and estate planning.
Conclusion
While it may seem obvious, investors should spend time considering their tolerance for risk and how their portfolios should be invested. It is highly likely that an investor's decisions on asset allocation will be the single most important factor in the rate of return for their portfolio. Asset allocation is a decision that is that important.
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1 ) The compound annual growth rate of return represents the average rate that an investment would grow each year over a given time frame. Properly calculated, the statistic factors out additions and subtractions from an investment portfolio in order to show only how the underlying investments performed. Albert Einstein called compound interest the eighth wonder of the world.
Disclosures and Disclaimer
Data shown in the charts above is provided by Ibbotson Associates and Stewart and Patten. This analysis deals with a limited number of asset categories. There are dozens of other asset categories that investors could choose to invest in. While long-term historical returns are a benchmark for future long-term returns, past performance, nor anything in this document, should be viewed as a guarantee of future performance.
