Defining the holy grail of investing is easy. Achieving it is hard. I define it as additional returns without greater risk.
Most investors don't appreciate that increased returns typically involve more risk. You can get a higher return on lower rated bonds, but the risk of default is higher. There's no free lunch. Or is there?
Here's an example of an exception to the rule. A small community bank offers a higher interest rate on its Certificate of Deposit than a large national bank. Both banks are FDIC insured and the amount of your deposit is within FDIC coverage guidelines. By purchasing the higher interest rate CD, you have obtained more return, but have incurred no additional risk.
Here's another anomaly I recently discovered. I was asked by a wealthy prospective client to put together a laddered portfolio of low cost, bond index funds. The client was adamant that he wanted no exposure to the stock market, because he is concerned about the risk.
A laddered portfolio staggers the maturity date of the bonds. When the bonds mature, the investor can reinvest the proceeds, taking into consideration the interest rate climate at the time.
I had suggested to the client that he read The Big Short, by Michael Lewis. It's my belief that anyone who reads that book would never do business with any broker, and would be especially terrified of purchasing individual bonds. I also referred him to excellent study from Vanguard which explained why bond investors should use bond funds and not individual bonds. Among the advantages of bond funds noted were diversification, cash-flow treatment, liquidity and costs. To those benefits I would add honesty and transparency, both of which are in short supply at your brokerage firm. He was persuaded by this data, but here's what neither of us expected.
We built a ten year ladder of very high quality, low cost, passively managed, bond funds and ran the returns for the period from January, 1973 to August, 2010. We wanted to measure the returns over a significant period of time so they would be representative.
This laddered bond portfolio had an annualized return of 6.71%, with a risk (as measured by standard deviation) of 4.27%. Standard deviation measures volatility of a portfolio (or stock or bond). It shows how much variation there is from the "average" over a given period of time. A low standard deviation means the portfolio measure is unlikely to deviate significantly from its average, based on historical data. While standard deviation is not predictive, it is a useful historical measurement of risk.
This data told us the ten year laddered bond portfolio we constructed had a very decent annualized return, with low risk.
We wanted to find out what would happen if we added a globally diversified portfolio of low cost, passively managed, stock funds to the mix. The stock portion would make up only 15% of the portfolio. We reduced the bond ladder to five years. Here's what we found:
The annualized returns increased to 7.16% and the risk decreased to 3.72%!
For those who believe I have cherry picked the numbers, or used an unrealistically long time period, I ran the returns for this portfolio for the past ten years, which is often incorrectly referred to as "the lost decade."
The portfolio had an annualized return of 4.14%, with an annualized standard deviation of 2.74%. An investment of $50,000 grew to $75,250.68. Nothing was "lost."
How can that be? We added a riskier asset class which we expect would increase returns, but it should also have increased risk. It didn't. The explanation can be found in Modern Portfolio Theory, the Nobel Prize winning work of Harry Markowitz, which explained how to construct optimal portfolios for a given amount of risk.
It's possible to achieve decent returns with relatively low risk. A portfolio of 100% bonds may not be less risky than a portfolio with a small exposure to the global stock markets.
Don't expect to get this advice from your broker.
The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.
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May I also assume that your modeled portfolio contained common bonds that were widely considered low-risk during the historical period you chose (eg, GM, AIG, WaMu, Lehman, Bear, etc) and that your returns reflect the appropriate haircuts?
Throughout my 43 year investment career, I have relied heavily on the basic framework for controlling risk first elucidated by Harry Markowitz in Portfolio Selection and since expanded by many academics and practitioners. (I estimate future correlations among assets and sectors rather than accepting average historical relationships to avoid the problem of correlations converging towards 1). My firm's objective is to avoid serious loss and to produce healthy and relatively stable positive returns, which is quite different from trying to outperform an equity benchmark over any short term period. Ironically we have found that our risk-avoiding, long-term approach has led to long-term results superior to our long-term equity benchmarks.