Modern Portfolio Theory suggests that diversified investment mixes over time should generate the lowest returns with more conservative allocations to stocks and the highest returns using higher allocations to stocks. Allocations with nearly equal weightings between stocks and bonds should have performance that is between those of the conservative and aggressive mixes. But over the past decade, performance for globally balanced portfolios has not followed expectations.
The following table documents two problems that have come to define investment management in the 21st Century. One is the 10% problem. This refers to an assumption that became well ingrained by the end of the 1990s that even a balanced portfolio of stocks and bonds could produce annual average returns of 10%. From 1973–1999, a balanced mix of 60% global stocks and 40% bonds returned 12.53% per year. Even adding in tougher markets since then, this same balanced mix returned 10.27% per year on average from 1973-2011.
The declining returns represent the second problem—that investors have not been paid well for taking on risk since 2000. You can see in the middle row of the table below that from 2000–2011, the range of returns is backwards of what portfolio theory suggests they should be. The most conservative portfolios – with the least fluctuation of returns – also produced the best average annual returns. The 2011 returns mimicked the now decade-plus pattern.
|
100% stocks |
80% stocks / 20% bonds |
60% stocks / 40% bond |
40% stocks / 60% bonds |
20% stocks / 80% bonds |
|
|
Average annual return 1973-2011 |
11.66 |
11.14 |
10.27 |
9.63 |
8.83 |
|
Average annual return 2000-2011 |
3.81
|
4.61
|
5.19
|
5.57
|
6.19
|
|
2011 |
-2.09 |
-0.50 |
2.26 |
4.06 |
6.40 |
100% stocks = 60% large cap, 10% small cap, 25% international, 5% real estate
80% stocks / 20% bonds = 42% large cap, 11% small cap, 24% international, 5% real estate, 18% bonds
60% stocks / 40% bonds = 32% large cap, 5% small cap, 17% international, 5% real estate, 41% bonds
40% stocks / 60% bonds = 22% large cap, 3% small cap, 12% international, 3% real estate, 59% bonds
20% stocks / 80% bonds = 9% large cap, 2% small cap, 5% international, 1% real estate, 82% bonds
Indexes: Large Cap = S&P 500. Small Cap = Ibbotson & Assoc. 1974-78, Russell 2000 1979-2011. International = MSCI EAFE. Bonds = Barclays Capital U.S. Aggregate. REITs = NAREIT Equity REIT Index.
Certainly, most financial plans and pension payment assumptions are calculated using returns better than the 4-6% range that balanced portfolios have provided since 2000. While the returns of these diversified portfolios are sobering, it is helpful to understand that stock market returns in particular have historically provided more support to longer-term financial security.
Consider the table below showing the allocation of returns for the S&P 500 over the past 85 years. The odds are certainly in favor of meaningful stock returns. The most important consideration in taking advantage of the good years is to manage investments so that the impact of the negative markets is reduced.
Source: Russell Investment Group
~ Brooks, Hughes & Jones, Partners in Wealth Management, Tacoma, WA
