The correct answer to yesterday’s “quiz” question was B!
The annualized return of portfolio A is only 3.9% even though the average return is 5%. How?
$1,000,000 invested in Portfolio A grows to $1,210,000 while $1,000,000 invested in B grows to $1,276,282. The total returns between A and B are about 21% and over 27.6, respectively.
If given the two options presented yesterday we’d choose Portfolio B all day and would be thrilled!
VOLATILITY KILLS! For example, a 50% loss requires a 100% gain just to get back to even while a 20% loss requires just 25% to get back to even. Volatile investments/portfolios require much higher returns to make the volatility worthwhile. This is why we get the results from yesterday’s hypothetical.
One takeaway from this exercise is that when analyzing investments (or portfolios more broadly) we cannot simply look at returns in a vacuum. We MUST also consider the risk taken to achieve those returns otherwise we’re only getting half the story and, potentially, making poor decisions.
Real World Example
Below are the annual returns from 2000 through 2020 for three major assets (U.S. Stocks, Treasury Bonds and Gold). The last column includes the annual returns of a blended, diversified portfolio composed of 50% Treasuries / 40% S&P 500 / 10% gold.
A few observations:
- The average annual return for stocks over this period was 8.2% while the actual annualized return was about 20% lower at 6.6%.
- The average annual return for Treasuries was 4.9% while the actual annualized return was very close at 4.8%.
- Why the large difference in average annual returns vs. actual “experienced” returns between stocks and bonds? Because the volatility of the stock returns was so much greater than the volatility of Treasury returns. Specifically, the volatility of the annual returns for stocks was almost 4x higher than Treasuries (17.8% vs. 4.8%)!
- The average annual return for the diversified portfolio was 6.8% (much lower than the 8.2% annual average for stocks). HOWEVER, the actual annualized return for the diversified portfolio was about the same as stocks at 6.6%. Why? Because the volatility of the diversified portfolio was about one-third the volatility of stocks.
- The volatility of the diversified portfolio was just 6.3% even though it’s composed 50% of stocks and gold, which had volatility of 17.8% and 14.9%, respectively!
This is why diversification is so important. The reduction in volatility is not linear when assembling non-correlated assets in a portfolio. This drastic reduction in volatility has a very real impact on returns over a full market cycle (including both the bull phase and the bear phase).
1 S&P 500 Total Return Index, 2 Bloomberg Barclays US Treasury Total Return Index, 3 Gold spot price, 4 Blended portfolio of 50% Bonds, 40% U.S. Stocks and 10% Gold (rebalanced annually)
Indexes are not directly investable and do not include fees, expenses or taxes.
Hypothetical Only! Past performance is no guarantee of future results. Not investment advice!