Stocks are risky but they generate high returns. Bonds are safer but they offer proportionally less returns. Investors may think that combining these asset classes in a portfolio linearly scales risk versus return. For the most part this is true; but due to a lack of correlation between these assets, combining them in a portfolio can actually increase returns without increasing risk.
Let’s take a look at the data going back to 1871. US stocks have generated an average annualized return of almost 9%. A mere $10 investment back in 1871 would be worth almost $2 million today with reinvested dividends. That’s a huge return; but the investor would have had to stomach a decent amount of risk, defined by standard deviation. In this same time period the standard deviation of yearly returns was 18% meaning that roughly 70% of yearly returns fall within a ±18% range of the average. That’s a lot of variation!
Meanwhile, intermediate bonds going back to 1871 yielded an annualized return of nearly 5% with a standard deviation of just over 4%. That $10 investment in 1871 would be worth almost $7,000 by the end of 2015.
But what happens when we combine varying amounts of stocks and bonds in a portfolio? The following plot shows risk (standard deviation of yearly returns) versus average yearly return for 40 different portfolios (blue dots). Adding a small proportion of stocks to a portfolio of bonds increases returns as one would be expected; but it does so while decreasing risk!
Now what happens when we add a third asset? Adding treasury bills, arguably the safest asset class available to an investor, again creates an opportunity to increase returns while decreasing risk.
The following table summarizes the performance of stocks and bonds going back to 1871 and includes two portfolios that highlight how combining stocks with bonds can increase returns without increasing risk.
|Stocks||Bonds||T-Bills||Portfolio 1||Portfolio 2|
|Standard Deviation (%)||18.0||4.4||2.6||4.3||4.4|
|Annualized Return (%)||8.7||4.6||4.2||5.1||5.5|
|Value of $10 Investment||$1,838,400||$6,700||$3,800||$13,400||$24,900|
|Real Value After Inflation||$97,000||$355||$200||$705||$1315|
|Largest Loss (%)||-43||-5||0||-4||-8|
|Frequency of + Years (%)||74||92||100||94||93|
In this example “Portfolio 1” had the same level of risk as a portfolio of just bonds; but the increase in returns by adding a small amount of stocks (9%) resulted in twice as much money in your pocket. Now if we are able to add treasury bills to the portfolio we’re able to increase the stock allocation to 20% while still maintaining the same level of risk. The increase in returns results in an investment growing to almost 4 times greater one in only bonds.
This brief analysis only looked at three asset classes, two of which were “safe” bonds. What happens when we add more risky stock asset classes? How much can we increase returns without taking on more risk?
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