Investors tend to underestimate the risk of loss especially at the tail end of a bull market that’s been raging for almost eight years. So let’s take a look history for some proper perspective.
One of the most important decisions an investor can make is the amount of risk they want to take on in their portfolio. This is usually practiced by first identifying an appropriate mix of fixed income investments (bonds) and equity investments (stocks) within the portfolio. Bonds typically being lower risk with stocks being higher risk. This “mix” is termed the Asset Allocation. The Asset Allocation is so important because it will determine over 90% of the volatility/risk you experience over time.
Below I’ve graphed the relationship between risk and return for portfolios of various “mixes” over the last thirty-six years. Risk is on the x-axis (horizontal) while return is on the y-axis (vertical). Green dots represent portfolios constructed using the same indexes but in different proportions (allocations). Check it out. Then I’ll dive into some observations.
Observation 1A: This one is obvious, intuitive and cliche, which is that the greater the risk the greater your return over time.
Observation 1B: The line formed by the various portfolios is not straight but is curved because the relationship between risk and return is not linear. In other words, you get less return per unit of risk the farther you travel along the curve when starting at the “80% Bond / 20% Stock” portfolio.
The implication is that you don’t get compensated for risk very well at the extreme fringe of the curve (i.e. 100% stock portfolio). By carving out just 20% of the portfolio for bonds you would have reduced your return only marginally but reduced volatility by about 1/5th!
Observation 1C: This one is for all you extremely conservative investors out there. A 100% bond portfolio is not the way to go although you may think you’re appropriately positioned given your extreme aversion to risk.
For instance, we notice by just adding 20% stock exposure to your portfolio you actually reduced volatility while also earning about 10% more return than that of the 100% bond portfolio (~7.9% vs. ~7.2%). More return for less risk.
The chart above defines risk as volatility, which measures the amount of movement in the portfolio value over time. That’s not always the risk investors are concerned about so, below, I plot the actual worst calendar year return against the long-term average annual return of the same portfolios. This time the annualized return is plotted on the x-axis while the y-axis contains the largest calendar-year decline. I’ll use the term “max drawdown” going forward to describe the decline.
Observation 2A: This is the same as Observation 1C above…by allocating just 20% to stocks with the rest in bonds you maintain roughly the same downside risk profile as if you had 100% in bonds but while maintaining a greater return over time.
Observation 2B: The max drawdown for very aggressive portfolios maintaining high allocations to stocks are severe. A 100% stock portfolio lost over 40% (in 2008), and remember this chart does not even include the Depression era.
Observation 2C: My third observation relates to the definition of “conservative” and “aggressive.” Of course, these terms are relative. A 60% stock portfolio may be too conservative for most younger workers, but the exact same portfolio could be considered too aggressive for older investors. But just the other day I heard a story about an advisor who told their 80+ year-old client that her 60% stock portfolio was conservative! Are you kidding me? I wonder if the “advisor” (and I’m using that term loosely here) mentioned the downside potential of the portfolio and asked this particular investor if she was comfortable with that risk. This is a common situation of setting unrealistic expectations / poor client education and contributes to the massive spike in client turnover at many advisory firms during market corrections and bear markets.
Observation 2D: Look at the difference in max drawdown between even the “40% Bonds / 60% Stocks” portfolio and the “60% Bonds / 40% Stocks” portfolio. The former having experienced a 22.4% drop in 2008 with the latter only losing 13.0% in the same year. In other words, the more conservative portfolio experienced only about half the loss of the what would appear to be just a “slightly” more aggressive portfolio but also managed to provide over 90% of the return for the period.
The two charts above illustrate why I never, or at least will rarely, implement either 100% stock or 100% bond portfolios for clients no matter how aggressive or how conservative they are. Neither of those portfolios makes sense. You don’t get compensated very well for the additional risk with the 100% stock portfolio, and, at least historically, you would have left risk-free money on the table with the 100% bond portfolio.
We’re just scratching the surface here on the historical relationship between risk and return, the importance of asset allocation, and the potential implications for your investment experience. However, I hope you find it helpful nonetheless!
Feel free to reach out to help determine what the best “mix” may be for you and your portfolio. There are many factors that need to be considered, including: risk tolerance, financial goals, resources, time horizon, bear market stress testing results, etc…
Note: Notice how high the historical returns have been? For instance, a 100% bond portfolio produced a 7.2% annualized return while an 80% bond portfolio produced 7.9%, etc… That’s not likely to happen over the next ten years. In fact, a more realistic expectation for returns over the next ten years is roughly one-half the historical returns highlighted in this commentary. More on that in coming commentaries.
Indexes used: US Stocks (60% of stock sleeve) = Russell 3000, Foreign Developed Market Stocks (30% of stock sleeve) = MSCI EAFE, Foreign Emerging Market Stocks (10% stock sleeve) = MSCI Emerging Markets, US Bonds (80% of bond sleeve) = Barclays Capital U.S. Aggregate, Foreign Bonds (20% of bond sleeve) = Barclays Capital Global Aggregate ex-US.
Past performance is no guarantee of future results. Always consult a professional who intimately understands your goals, resources, experience, and risk tolerance before making investment decisions.