Monday, June 13, 2011
Pop Quiz: Which Portfolio Has More Risk?
Here's the question: Based on historic data since 1950, which portfolio mix has a greater risk:
Choice A: 70% Stocks/20% Bonds/10% Cash
Choice B: 0% Stocks/90% Bonds/10%
The answer can be found at the end of this post.
I was at a Global Quantitative Strategy conference yesterday sponsored by Merrill Lynch. It was a very interesting day, with speakers focused on a variety of topics.
Simply put, the idea behind quantitative analysis is to use data-driven, computer analyses to find market opportunities. One goal that practitioners of quantitative analysis is to try to remove emotions from their investment activities.
I won't go into everything that was discussed yesterday, but will try to touch on a few of the presentations over the next few days.
The first speaker yesterday was Nicholas Barberis, a professor from the Yale School of Management whose specialty is behavioral finance.
Behavioral finance has become a "hot" area in investment management, since it attempts to incorporate how psychology can impact investment decisions.
Professor Barberis pointed out that most of us focus on the risk of events that have a fairly small likelihood of actually happening. Some of us suffer from the fear of flying, even though millions fly each year without incident. We demand vaccines or preventative measures for illnesses that have only the remotest chance of occurring.
In investing, most conversations I have with investors focus on the possibility of a repeat of the 2008 stock market meltdown, when the S&P declined by more than -30%. However, if you go back to 1926, there have been just 11 years that the stock market has declined by more than -10%.
Or, put another way, in 87% of the years since 1926 the stock market has either gained or experienced a small decline. Only 3 of the last 84 years (4%) of the years had declines that were of the magnitude of 2008.
And yet most investors I speak to these days are more focused on the risk of stocks than bonds, even though bond yields are historically very low.
So the Answer to the Pop Quiz, based on Ned Davis Research data:
Choice A has a negative return 23% of the time over the last 60 years. On average, the return of the 70% stock/30% fixed portfolio has been +15%.
But here's the surprise. Choice B - the all bond portfolio - has had a negative return 25% of the time (or slightly higher than the portfolio skewed towards stocks) but the average annual return has been slightly less than +10%, or nearly 1/3 lower than the portfolio having stocks.
Put another way, the all-fixed portfolio had more risk, and lower returns, than the equity portfolio.
So if you chose Choice A, consider yourself rational.