Expected Returns Based On Asset Allocation
A while back I was doing some research for another project when I stumbled on some data from Vanguard that I found particularly interesting.
The data illustrated historic returns based on asset allocation, all the way back to 1926.
There was a graph, which I have recreated below, that illustrates what a portfolio with a given ratio of stocks to bonds could expect to see in returns over time.
The graph also shows the top and bottom returns for the best and worst years in that span.
What follows are several observations I made based on this chart.
1) Stocks Provide Higher Returns and Volatility
As you might expect, portfolios that have a higher allocation of bonds tend to see lower returns but also provide lower downside risk that these portfolios will dip significantly in value in any one year.
Conversely, portfolios full of stock have a higher potential for gains but present the tradeoff of higher volatility from year to year.
This is a perfect example of how rates of return tend to follow risk. The higher the degree of risk, the more investors expect to be compensated for that risk and vice versa.
I do want to be clear, however, that just because an investment is in a bond that doesn’t mean it’s “low risk”.
After all, the financial crisis in 2008 was primarily initiated by the collapse of mortgage-backed securities which were graded inaccurately. (No, technically MBS’s are not bonds, but if it looks like a duck and quacks like a duck…)
The truth is there is a broad range of the quality of bonds and the value of any bond is dependent upon the creditworthiness of the bond issuer.
Standard & Poor’s, Moody’s, and Fitch Ratings are the three primary bond rating agencies.
Naturally, it would be too convenient for them to have a standardized grading system, but generally, bonds are rated on a letter scale like the grades you got when you were in school.
A is good, but D is not. If you see a combination of the same letter, it typically means it’s a higher-grade bond (i.e. ‘AAA’ is better than ‘A’).
At the bottom of the heap are appropriately named “junk bonds” which carry the highest degree of risk because the issuers are not considered to be on the most stable footing.
If a bond issuer goes into default, their bonds are almost completely useless. Bondholders are relatively high in the pecking order for compensation from the liquidation of a company’s assets in bankruptcy, but that’s nothing to be excited about.
For the most part, individual investors will elect to buy bonds via a bond mutual fund or ETF which will hold a wide range of bonds, issued by a variety of institutions with varying degrees of risk.
In summary, a well-diversified basket of bonds is certainly less volatile than stocks and overall, it will almost certainly be less risky too.
The chart seems to bear that out.
2) The Happy Middle Ground
We just discussed how the expected returns of an investment are correlated to the level of risk intrinsic to that investment.
In fact, if you look at the average returns on the chart, they follow a near-linear path with the shift from a bond-heavy to a stock-heavy portfolio.
Just look at the average return difference between the 0/100 portfolio and the 100/0 portfolio. The 100% stock portfolio earns exactly twice the average return (10.2% vs 5.1%).
It is interesting to me, however, that the range of volatility, while somewhat predictable, doesn’t follow a linear path.
It looks more like a funnel to me.
Now, just based on the appearance of the graphic alone, we can tell that there is a loss of correlation between two sets of data.
In this case, at certain asset allocations, the level of volatility doesn’t increase at the same rate that the average returns do. That means we can get more return without adding an incrementally equivalent amount of volatility (which can be considered a component of risk).
For example, by moving from a 0/100 asset allocation to 30/70, you gain exposure to higher average returns (7.0% vs 5.1%) without a proportional amount of additional downside risk (-15.0% vs -13.1%).
Two percent higher average annual return for a less than two percent chance that you will experience a slightly worse performing year in one out of the many years you hold the portfolio is a good trade.
This doesn’t necessarily mean you should hold a 30/70 portfolio, but the data seems to indicate a better balance between risk and reward than in a 0/100 portfolio.
3) Misleading Averages
The impact of the average returns is easy to misjudge if you don’t understand compounding interest.
As an average, the returns on portfolios heavily tilted toward stocks may appear to produce an unimpressive difference. So little, in fact, that you might even think the downside risk isn’t worth the potential upside.
In actuality, the cost of double the return between the 0/100 and 100/0 allocations (10.2% vs 5.1%) is 4.14 times the end value in compounding interest over the course of 30 years, 6.67 times the value in 40 years, and 10.7 times the value in 50 years.
So, a $10,000 investment would be worth $124,898 more in a 100/0 allocation after 30 years, $372,070 more after 40 years, and a whopping $1,052,107 more after 50 years.
That’s not so unimpressive after all.
The truth is even the smallest differences in the rate of return can grow to significant sums over time. Do your best not to give up ground here if you can help it.
If you have longer to invest, you’re taking a lot of risk by not using stocks.
4) Don’t Let the Range Fool You
If you look at the growing span of ranges between the highest and lowest performing years, you might be tempted to assume that a 100% stock portfolio is three times as dangerous as a 100% bond portfolio because the stocks lost just over 3x the amount of a bond portfolio in their worst year.
And that would be an incorrect assumption.
Once again, the truth is the range in this chart is misleading because each value that we see from the range is based on a single year while the average returns are based on 96 years.
There is no question that in their worst years, stocks are much uglier than bonds.
However, the inverse is also true. The pretty years for stocks are far more exciting than the best years bonds ever produce.
What we really need to see to understand the true downside risk of stocks and bonds is the performance of a variety of portfolios over time, not just data from a single point in history.
Thus, I give you this lovely graph from portfoliocharts.com.
What you are seeing is the performance of 3 hypothetical portfolios. In red are portfolios that contain 100% stocks, 60/40 stocks to bonds is represented in aqua, and the Coward’s Portfolio is in gold which I won’t bother describing here because it is irrelevant to this post.
Each portfolio represents a series of 44 investors who invested $10,000 each year from 1972 to 2015. The only difference is they each started in a different year.
Clearly, the 100% stock portfolios experienced the highest degree of volatility. The range from the peaks to valleys is definitely the largest.
But what is most interesting to me about this graph is the fact that the bottom of the 100% stock curves isn’t much lower than that of the 60/40 portfolios and it even stays above it beginning in year 27.
In other words, over time the downside risk of stocks has been overcome by the upside potential they have provided, historically speaking.
That’s all the upside without the downside, simply by holding the investment for a long time.
The natural conclusion is if you have enough time, there is little reason to select bonds over stocks.
And that’s why I tend to harp on an asset allocation that matches the timing of your needs with investments as opposed to an allocation tied to your perceived investment risk tolerance.
For monetary needs within the next two years, store your money as cash or cash equivalents in savings accounts or money market funds.
For needs that are two to five years down the road, bonds provide a comfortable mix of stability and returns that are normally better than what you will see in high-yield savings or money markets (though 2024 has been an exception).
For needs that are 5 or more years down the road, stocks bring the best returns. And since you’ll be holding them for at least 5 years, you’ll have time to ride out market volatility.
Of course, a portfolio invested heavily in stocks is not for the faint of heart.
If market volatility might cause you to make drastic changes to your portfolio out of fear, then you should be invested conservatively enough to prevent you from bringing harm upon yourself that way.
Conclusion
The bottom line is asset allocations based on randomly selected ratios of stocks to bonds are not optimal.
Sure, these asset allocations provide diversification, but could someone please explain to me why that is necessary for monetary needs that are more than 5-7 years down the road?
The only cases I can make for asset allocations based on ratios are:
- It’s simple and sometimes simplicity is the best way to arrange an investment portfolio depending on the investor;
- Some investors cannot handle sudden, dramatic market downturns without panic selling their stocks. In this case, the investor should use whatever ratio gives them peace of mind.
Beyond these two exceptions, I implore you to align your asset allocation with when you plan to use the money. It is clearly the best path to optimal portfolio returns.
