Historical Portfolio Returns

December 25, 2016

Merry Christmas Everyone!

This week I will look at the historical performance of different portfolio allocations.  Also, a comparison of this year’s performance to long term averages.  There are a few surprises.

In the weeks since the election, there has been a strong demand for risk, lifting the broad SP500 index by 8%. So how goes it over on the safety side of the ledger? Holders of an index of the total bond market, VBMFX or BND, have seen a price drop of a bit more than 3% since the election, but a net gain of 2-1/4% in the past twelve months.  Almost all of that gain is the yield, or interest earned on the bonds.  Inflation eats up most of that net gain, leaving the bond investor with little net gain for the year, but no loss.

 Morningstar provides a comparison table of various investments.  The AGG broad bond index in their table has an average total return of 2.18% over the past five years.  Yes, this year’s rather low return of 2.25% is better than the five year average.

Vanguard provides a 90 year comparison of various portfolio allocations and it is the first one on the page that I’ll turn to.  Over 90 years, the average total return of interest and price appreciation on a 100% fixed income, i.e. bond, portfolio is 5-1/4%, or 3% more than this year’s total return.

In today’s low yield universe, there is little difference, or spread between today’s yield on a broad bond index and that on a broad stock index.  Over that 90 year period, stocks have averaged 10% per year total return.  The difference between the average total return on bonds and stocks is almost 5% and is called the risk premia.  It means that, on average, a bond investor sacrifices 5% annual return for the income and the relative price stability of bonds. That’s the 90 year average.  The 5 year average tells quite a different story: a 15% per year total return for the SP500 vs 2.18% for a broad bond index.  That risk premia is 2-1/2 times the 90 average.   Seniors and others needing safety have paid a high price.

OR…let’s look at this from a different perspective.  In the long run, the law of averages is like gravity. What price would the SP500 be if its total return were more in line with the 90 year average of 10%?  The answer is a price that we last saw during February of this year – about $1840.  That is an 18% drop from today’s current price of $2264.

As the generation of boomers continues to draw down savings to supplement their income, we can expect that price stability will become more valued.  That should balance some of the downside price risk of owning bonds in an environment of rising interest rates.  There are some countervailing forces.  Oil states may derive more than half of their revenue from profits based on the price of oil.  When oil prices were high, the sovereign funds of these states bought U.S. Treasuries and other assets with the excess profits.  As prices declined since mid-2014, the lower revenues have produced budget deficits in those countries dependent on oil.  They have already sold some assets and will continue to do so if prices remain below $60 a barrel.

Comfortability Ratio

The Vanguard table of returns for various allocations (see above) shows that a 60% stocks/ 40% bond portfolio allocation (60/40) produces the best total returns of the choices for a balanced portfolio.  Let’s look at a comfortability ratio – the average return divided by the percent of years with a loss, or %AR / %YL.  This can be an important psychological ratio for those approaching and in retirement.

As many studies have shown, we give more weight to losses than gains.  We are naturally risk averse, and especially so as we near the end of our working years.  Higher comfort ratios are safer.  A 40/60 and 50/50 allocation have comfort ratios of .44.  Their average return is 44% of the percent of years that an investor suffers a loss.

Ranked by this comfort ratio, the surprise is that a 60/40 allocation acts more like a growth, not a balanced, allocation.  70/30 and 80/20 growth allocations have the same .37 comfort ratios as the 60/40.  On a more surprising note, a strongly agressive 90/10 allocation with a .38 ratio  has a better comfort ratio than any of these growth allocations.  Here’s a table:

Allocation Avg % Years Comfort Ratio
                   Return    With Loss
40/60 7.8 17.7 .44
50/50 8.3 18.8 .44
60/40 8.7 23.3 .373
70/30 9.1 24.4 .373
80/20 9.5 25.5 .373
90/10 9.8 25.5 .384
100/0 10.1 27.8 .364

Allocation based on income needs

As an alternative to conventional allocation models using percentages, an investor might keep five years of income needs in bonds and cash and devote the rest to equities. An important caveat: income needs do not include emergency cash. Using this model, an investor who needed $20K from their portfolio each year, would keep $100K in bonds and cash, and put the rest in stocks.  A 35 year old with no income needs would have 100% in equities.  This model naturally becomes more conservative as the portfolio is drawn down.

For two years the stock and bond market have seen little net change.  Investors might have become complacent.  Since the election, the shift in sentiment has been strong and investors should check their year end statements and make adjustments based on their needs and targets.

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In a country far, far away….

Cue the Star Wars theme. Dah, dummm, dah, dah, dah, dummmmm.  In 2008, China overtook Japan to become the country that holds the largest amount of U.S. Treasuries. Since this summer, China has been selling Treasury bonds to support its currency, the yuan, and is now again in 2nd place.  As long as the dollar continues to rise, China is likely to continue this practice which will maintain a slight downward pressure on bond prices.

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