Crackerjack Greenback Prudent Advice for a Prosperous Future

December 22, 2008

Comparison of the Diversified Portfolios

Filed under: Diversified Portfolios,Investing,Retirement Planning — Paul Williams @ Crackerjack Greenback @ 2:52 pm

       In the last post of my series on a closer look at a diversified portfolio, reader Nick asked if I could do a summary post comparing all the portfolios. I’m quite happy to oblige as it was something I was hoping to do anyway.

       First, let’s look at the historical performance and risk of all the portfolios. The chart below shows the average (arithmetic mean) return and standard deviation (a measure of risk) for each of the portfolios starting with the 100% Stock portfolio down to the 0% Stock (100% Bond) portfolio. The data used was from the time period of 1927 to 2007.

Historical Return and Volatility of Portfolios - Small

       We can clearly see that as you have a higher percentage in stocks your return goes up—but so does your risk. This is called the risk vs. return trade-off. A higher return generally means higher risk is involved, and lower risk generally means you’re going to get a lower return.

       The average return doesn’t really tell us much as we’ll probably never actually get the average return in any given year. Investment returns fluctuate, so it’s nice to see the range of returns we would have experienced in each portfolio. This next chart shows exactly that. For each portfolio, I’ve charted the highest, average, and lowest return over the 1927-2007 time period.

Portfolio Return Ranges (One Year) - Small

       Again, that’s all fine and dandy but it still doesn’t tell us much. When we invest, we generally don’t have a one year time frame so we shouldn’t be looking at single year returns. Most of the goals we invest for have time frames of 5, 15, or 30+ years. What we really want to know is how our returns will look over those time periods. How likely is our portfolio to lose money over 5, 15, or 30 years? What’s the lowest return the portfolio has experienced over a 30 year period? Those are the questions we should really be asking.

       To answer those types of questions, we have to look at things a little differently. For starters, we can’t use the average return over a 30 year period to figure out what the portfolio would have done. Because investment returns compound and vary each year, we have to use the geometric mean (click to learn more). This is also called an annualized return. It basically means that your return over a given time period would be like getting the annualized return every year—except that never actually happens in reality because investment returns vary from year to year.

       For example, an annualized return of 10% over a 5 year period means that $1,000 would have grown to $1,610.51. But your actual returns could have been very different. One 5 year period might have returns of 9%, -15%, 8%, 16%, and 39% while another 5 year period might have returns of 14%, 12%, -5%, 8%, and 23%. The average return for these periods was 11.4% and 10.4%, respectively, but you still would have ended up with about $1,610.51 in both of those 5 year periods.

       To really see the effect that time has on reducing our risk of losing money, we’ll have to keep the scale on the charts the same. So each chart has a highest return of 100% and a lowest return of -60%, even though none of the results actually go to those extremes. Let’s look again at the chart for the one year periods, then I’ll show you the 5 year, 15 year, and 30 year charts without interruption so you can really compare them all.

Portfolio Return Ranges (One Year) - Small

Portfolio Return Ranges (Five Year) - Small

Portfolio Return Ranges (Fifteen Year) - Small

Portfolio Return Ranges (Thirty Year) - Smalll

       Wow, that last chart is really bunched up isn’t it? What does that tell us? The longer we leave our money invested, the more likely it is we’ll get a result closer to the average. If you’re invested heavily in stocks, it also means that you’re more likely to get much higher than average returns as well. This is why you should be invested in a 100% Stock portfolio if you have more than 20-25 years until retirement, and it’s why you should probably have at least 70-80% in stocks until you actually do retire. By leaving most of your money in stocks for a long time, you increase your chances of getting the high returns you need while decreasing your chances of getting very low returns (for the entire time period your money is invested). Yes, you’ll have more volatility, but that won’t matter if your portfolio has grown large enough to exceed your needs.

       So do you want to see what those returns were like over the 30 year periods? The chart below is zoomed in with a better scale so you can really see the results.

Portfolio Return Ranges (Thirty Year) Zoomed In - Small

       Look closely at the data for that 100% Stock portfolio. The worst annualized return you would have had over a 30 year period was about 8.5%. Even if you invested just as the Great Depression was getting underway, you still would have made 8.5% a year over 30 years. That’s pretty amazing, and it’s exactly why we need to block out the noise from the financial media. Ignore the short term, invest in index funds, and go about living your life and enjoying your family and friends instead of watching the stock market all the time!

2 Comments »

  1. Thank you. This has been a great series.

    Comment by Nick — December 23, 2008 @ 7:27 am

  2. Glad you liked it, Nick! Let me know if you have any other questions you’d like answered. 🙂

    Comment by Paul Williams @ Crackerjack Greenback — December 23, 2008 @ 4:22 pm

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