The trade off between Risk and Return is something that will always be talked about when it comes to investing. Unfortunately, while investors seem to indicate that they understand the concept, they normally don’t in reality. This can be due in part to short term focus with long term investments and lots of “noise” from friends, the newspapers, TV, etc that serve to make one second guess themselves all the time.
Let’s Make It Visual
I’ve put together a graphical back test of 10 portfolios that vary in exposure to equities from 10% equity to 100% equity. The 100% equity portfolio is allocated as follows:
35% Canada
25% US
25% EAFE
15% Emerging Markets
The 90% equity portfolio has 10% exposure to fixed income (which is represented by the DEX Canadian Broad Bond Index). Each of the equity components’ percentage allocation is reduced by 10% accordingly, such that the 90% equity portfolio looks like this:
31.5% Canada
22.5% US
22.5% EAFE
13.5% Emerging Markets
10.0% Fixed Income
…and so on, until the 10th portfolio is only 10% equities and 90% fixed income and looks like this:
3.5% Canada
2.5% US
2.5% EAFE
1.5% Emerging Markets
90% Fixed Income
Here is how they each looked from the period of January 1988 until August 2008, assuming annual rebalancing and no transaction costs or other fees:
(Click image to enlarge)
(Graph created using software from DFA Canada Inc.)
The “safest” portfolio which was 90% fixed income would have taken $1 and turned it into $6.04 during this time. The “riskiest” portfolio which was all equity would have taken this $1 and turned it into $7.96. To put this into perspective, consider that this represents an increase of 31.79% of the end amount.
Alternatively, you can think of $100,000 turning into $604,000 versus $796,000.
But, what’s the conclusion?
Are the additional profits worth the additional risk?
How isthe additional risk measured?
I suppose a significant factor in selecting the ‘correct’ allocation will ultimately depend on time frame and goals, since if you had taken the same analysis, but began 1 year earlier (Dec 86), the results would probably look a little different. Also, what if you had charted the same comparison, but began in 1999. The difference would likely be less dramatic.
A picture is worth a thousand words. This graph tells me a lot – and thank you for using such a nicely diversified portfolio – quite nicely done! I’m printing this out and putting it up in my office.
Hows the spread doing after today’s massive drops? I sure hope the people in the 90/10 portfolios don’t need their money any time soon :)
I assume that the portfolios are not being rebalanced periodically. It would be very interesting to see how annual re-balancing would affect the graph. Would it just moderate the highs and lows?
A log plot would be revealing too since it is difficult to see the variations in value when the values are smaller.
I also find it amazing that the graph isn’t exponential and appears very linear (especially the 90%fixed/10% equities). What happened to compound interest?
Interesting, nonetheless.
@Mark – in this case the risk is measured via standard deviation, which is not the only measure. Conclusions? You need a long time for buy and hold to work out – perhaps one should consider using options? :)
@Sampson – I will make a separate post later this week to show just what you describe.
@Peter – glad to be of service. :)
@Traciatim – I’ll put up data to end of September when the files are available – guess is that it still holds up although not as convincing. Of course if someone needed to take out all their money at once they’d be ill-advised to have so much money in equities. But if they have a 30 year potential retirement, significant exposure to equities isn’t too scary to me.
@Aaron – portfolios were re-balanced annually. Again, I will post later this week with scenarios suggested or asked for by commenters – including not rebalancing, and I will have a log plot too for both.
If you do a non-rebalancing graph, it would be interesting see how the allocations drifted after 20 years.
Thanks,
Dan.
@DG – will do, hope to get this done for Monday’s post. As you can imagine, not rebalancing can look good simply because the higher performing asset class will increasingly represent more of your portfolio so over time the portfolio return drifts up towards the highest performing class. (Risk goes up too)