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Perhaps the biggest job that any investor has is managing risk. If you take too much, you could be flirting with disaster; if you take too little, you could cheat yourself out of the returns you need to take care of yourself, your family and your heirs. In this article, Paul Merriman shows how to get this important equation just right.
One of the most fundamental decisions faced by every investor is how to
allocate a portfolio between stocks and bonds (or the way we do it,
between equity funds and bond funds). Some investors prefer a total
equity portfolio for its superior growth prospects. Others invest
exclusively in fixed-income instruments, preferring to completely avoid
the risks of the stock market. But most people in my experience are
more comfortable somewhere in between those two extremes.
Yet the question remains: Just how far should you go in one direction
or the other? One very good approach is to split all investments
equally between stocks and bonds. We also advocate equal allocations to
U.S. and international funds and to large-cap and small-cap stock
funds. We also favor indirect ownership (through funds) of value stocks
and growth stocks, though we recommend overweighting slightly toward
value.
Table: Balanced Asset Class Portfolios (1970-2007)
Fine Tuning Your Asset Allocation
Equity portion is 50% US / 50% international
One percent annual management fees assumed
This division gives investors excellent representation in all the major
markets. It’s also very easy to understand. No matter what part of the
investment world is “hot” at the moment, such a portfolio will take
advantage of it.
Of course not everybody wants to split things 50/50, and there is a
wide range of other possibilities. You will see some examples in the
large table of performance figures. The table shows the results of 38
years of buy-and-hold investments allocated between stocks and bonds in
10 percent increments, from 100 percent bonds (on the left) to 100
percent stocks (on the right). In the final column, you’ll see the
annual performance of the Standard & Poor’s 500 Index, a standard
equity benchmark that is tough to beat over prolonged periods.
At first glance, this table may look daunting. It contains 456 annual
performance figures, each one representing what investors got, or would
have gotten, in a particular year using a specific allocation strategy.
In addition, we include another 72 figures, six at the bottom of each
column, summarizing the results of each strategy.
Before you let your mind go numb, please let me walk you through this
table. Once you get the hang of it, I think you’ll find it can be an
excellent tool for deciding how to allocate your assets between equity
and fixed-income securities.
WHAT IS THIS TABLE?
The table shows the results of investments made in a particular group
of asset classes and asset class mutual funds that are not available to
the public except through registered investment advisors (including
Merriman Berkman Next). The funds are managed by Dimensional Fund
Advisors (DFA), a company whose work is based on some of the finest
academic research ever done on investment returns. This research, the
indexes, and the optimum way to put them together are described in an
article titled “ The ultimate buy-and-hold strategy ."
In that article, we focused on an allocation of 60 percent of assets in
equities and the other 40 percent in fixed-income. You’ll see the
results of this allocation in the column in the large table marked “60%
Equity.”
If you trace the numbers in that column down from the top, you’ll see
the year-by-year performance of the 60/40 strategy from 1970 (up 2.9
percent) through 2007 (up 4.8 percent). Continuing downward, you’ll see
that this strategy produced a compound rate of return of 11.3 percent;
its standard deviation, a measure of volatility in which lower numbers
mean lower volatility, was 10.4 percent.
To put that 10.4 percent figure in context, scan over to the far
right-hand column and you’ll see that the S&P 500 Index had a
standard deviation of 16.6 percent. This means that this 60/40 split of
stocks and bonds carried approximately 63 percent of the volatility of
the U.S. stock market.
While you’re at it, put one finger on the “Annual Return” line (this is
a compounded rate of return) of the 60/40 column and another finger on
the same line of the Standard & Poor’s 500 Index column. You’ll see
that the Ultimate Buy-and-Hold Strategy 60/40 combo had almost
identical performance as the U.S. stock market while keeping 40 percent
of the portfolio in fixed-income securities, without being exposed to
stock-market risks.
THE BEST OF TIMES, THE WORST OF TIMES
If you’re with me so far, you know how to read this table, and you’ve
probably scanned a few of the other columns as well. But before we go
on, look at the bottom four lines of each column. These figures show,
in percentage terms, the biggest losses you would have sustained for
each allocation. These are the worst month and the worst one, three,
and five-year periods. Note that these are not calendar years. For
these lines in this table, any “worst” period could start at the
beginning of any month.
These figures are useful because they show the losses you must be
willing and able to tolerate in order to stick with your strategy. This
isn’t pleasant territory, but you’ll be far better off to spend some
time with this topic than to just concentrate on the fabulous returns
you might get. In real life, you’ll never get those returns if you
don’t stick with the program you select. And you won’t stick with the
program if the periodic losses push you out of your comfort zone and
prompt you to bail out and sell your holdings at the worst possible
time, when things look bleak and you’ve sustained some significant
losses. You would have a tough time recovering from that, both
financially and emotionally.
The reason we put so much attention on measuring and managing risks is
that this is exactly where so many investors get tripped up. Spend some
time thinking about how much of your portfolio you are really willing
to lose in a month or a year. Run your fingers back and forth on those
bottom lines and search for a combination of losses you think you could
tolerate.
That, in fact, is what the table is all about: giving you a way to find
the column, and hence the asset allocation, that’s right for you.
WHAT THIS TABLE TELLS ME
When I study this table, one of the first things I notice is the
difference between the 100 percent equity portfolio and the Standard
& Poor’s 500 Index. If you’re looking for high return from
equities, you can see that the diversified all-equity portfolio was
clearly superior to the S&P 500, with a 22 percent improvement in
compound rate of return (13.7 percent vs. 11.2 percent).
I think this is dramatic evidence of how important it is to diversify
with non-correlated investments. The all-equity portfolio combines
multiple asset classes, every one of which by itself has a higher
standard deviation than the S&P 500. Yet when you combine them,
they often offset each other and produce a lower composite standard
deviation.
This table shows that diversified portfolios gave investors a chance to
approximately equal the return of the S&P 500 with only a 60
percent exposure to equities.
If you are looking only for the highest performance on this table,
you’ve found it in the all-equity diversified portfolio. That’s a
strategy we recommend for investors who can tolerate the risks. We
think those risks are very reasonable for that performance. But 13.7
percent a year may be more than you need to meet your goals. And the
risks may be too high for you, especially that 35.1 percent loss in the
all-equity portfolio in the worst 12-month period during these 38
years.
Based on many years of talking to clients and polling people who attend
my workshops, I have concluded that most retired people regard a return
of 8 to 12 percent, compounded annually, to be satisfactory. And most
people say they are willing to lose 10 to 20 percent of their assets in
any given year (though certainly not year after year!) to achieve such
a return.
SEVERAL GOOD OPTIONS
The good news is that there are several combinations in this table that
exceed those specifications. On the conservative end, the 20 percent
equity portfolio produced a compound annual return of 8.5 percent, and
its largest calendar-year loss was only 3.1 percent (1994). You’ll find
higher returns (and higher yearly losses) in the 30 percent and 40
percent equity portfolios. Note that the 50 percent portfolio had a
compound annual return of 10.6 percent and a maximum calendar-year loss
of 10.2 percent (1974). That loss followed on the heels of an 8.1
percent loss in 1973. But for comparison, look what happened to the
S&P 500 Index in those two years: down 14.7 percent in ’73 and down
another 26.5 percent in ’74.
You’ll also see that the standard deviation of the S&P 500 was
nearly twice as high (16.6 percent) as that of the 50 percent equity
portfolio (8.9 percent). You might also note that the standard
deviation of the 30 percent equity portfolio, which produced a
respectable compound return of 9.2 percent, was less than 40 percent as
high as that of the Standard & Poor’s 500 Index.
Here’s how to make this table a useful tool for you individually. Start
by writing down two numbers: the target return that you need (after you
add one or two percentage points to give yourself a margin for error)
and the largest one-year loss you are willing to tolerate. Then start
with one of those figures and scan the table to find an allocation that
gives you what you need.
HOW MUCH DO YOU WANT?
Investors typically say they want the highest possible returns. But
when you suggest they put all their money in pork belly futures
contracts or bet their life savings on Google stock, they quickly
change their tunes. Still, if you are like most people you want as much
as you can get. So start with the all-equity column and work your way
to the left until you find a column where you can tolerate every risk
item, including the worst 12-month, 36-month and 60-month periods. When
you find that column, you have an idea what percentage of equity
allocation might be right for you.
Some risk-averse investors won’t want to tolerate the bad times
associated with the allocation that will give them the returns they
need. If you really need at least a 12 percent return, for example, you
may still find the risks of the 70 percent equity portfolio are too
high for you.
What should you do if you need the returns from a column that has too
much risk for you? Your first impulse might be to go for the high
return and ignore your gut in regard to the risk. But I think that
would be a big mistake. If your needs straddle two columns, choose the
one that has the right level of risk for you.
There are two main reasons for this. First, remember that the figures
in the table are not predictions of the future, only hypothetical
results from the past. And the past is a more reliable indicator of
risk than of returns. For any given combination of assets, the pattern
of volatility is likely to be more predictable than the pattern of
return.
When our financial advisors work with clients and project future
returns, they usually assume two percentage points less than the
returns shown in this table. That is a conservative position, and it
reflects our belief that returns from 1970 through 2007 were higher
than those that investors should expect in the future.
Second, it is never acceptable or advisable to manage a portfolio in
violation of your risk tolerance. Year after year, decade after decade,
we see people who have to learn that lesson the hard way, making it an
extremely expensive lesson. They are typically the ones who bail out of
their investments near the bottom of a market cycle. They become bitter
and cynical about investing. Worse, they often stay out of the markets
for many years, sometimes even permanently, for fear of being burned
again.
LISTEN TO YOUR GUT
If there is only one lesson you take from this article, I hope it
is this: Never ignore your emotions or your “better judgment” in order
to chase higher returns. It’s just not worth it. When we talk to
clients who need or want higher returns than their guts will allow, we
spell out a few options, which of course they already know about.
We often recommend that investors settle for lower returns in order to
reduce their risks. If you do that while you’re still working, you
might have to work longer or save more each year before you retire. But
that is much better than retiring with too little money. If you are
already retired, accepting lower returns might mean you can spend less.
But that is far better than suffering losses that put you in danger of
running out of money.
You may be able to increase your tolerance for risk with education. But
for most of us, risk tolerance or risk aversion is a character trait
that’s part of who we are, not subject to much change. So unless you
are certain that you are comfortable with higher risk, listen to your
gut.
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