Lessons From Recent Market History

October 13, 2003
What are the painful lessons that we should learn from recent financial markets' history? To answer this question, let us review the graph below, which presents 1987-2002 returns on S&P 500 stocks, high-grade corporate bonds and portfolios of these two asset classes with stock weights of 25 percent, 50 percent and 75 percent. Each portfolio is rebalanced back to its original weights at the end of each year.
During those 15 years, stocks beat bonds by 1.76 percent per year. The additional return for each 25 percent increment in stocks, however, is not linear. The 25 percent stock portfolio earned about 40 percent of the additional returns. The 50 percent stock portfolio earned about 75 percent of the additional returns, while the 75 percent stock portfolio earned about 90 percent of the additional returns.
The pattern for standard deviation -- as a measure of risk -- also is favorable. Stocks had about twice the level of volatility as bonds. The additional risk for each 25 percent increment in stocks, however, is not linear. The 25 percent stock portfolio had a similar risk to the All-Bonds portfolio. The 50 percent stock portfolio had about 20 percent of the additional risk, while the 75 percent stock portfolio had about 60 percent of the additional risk. Although these precise results were specific to 1987-2002, the lessons to be learned from this period apply to other long-term periods.

Lesson No. 1: Mixing bonds and stocks moderates portfolio risk.
High-grade bonds and stocks are fundamentally different assets. Thus, their returns do not vary closely. Adding bonds reduces the risk of an all-stocks portfolio, but adding some stocks may not increase the risk of an all-bonds portfolio.

Lesson No. 2: Portfolio returns rise disproportionately quickly as stocks are added to the portfolio. See information above.

Lesson No. 3: Portfolio risk rises disproportionately slowly as stocks are added to the portfolio. See information above.

Lesson No. 4: Rebalancing helps you maintain a stable risk exposure and overcome inertia.
If your optimal trade-off between risk and returns calls for 50 percent stocks and 50 percent bonds, then periodically you should rebalance back to this target to maintain a stable risk exposure. Furthermore, rebalancing helps investors overcome inertia. Without this discipline, many investors do nothing because they are not sure what to do.

Lesson No. 5: Maintain a diversified stock portfolio.
This last lesson does not come from the table shown here. The table assumed the stock portfolio was the S&P 500, which contains stocks across all sectors. From my experience, many families' biggest mistake was holding a stock portfolio that was concentrated within one or two sectors, especially technology. Mixing bonds and stocks will not adequately diversify a portfolio that is overexposed to a few sectors.




table










































Risk & Returns for Five Portfolios:
1987-2002
(All portfolios rebalanced annually)
Š
Portfolio

Standard
Deviation
(Risk)Š

Average
Annual
Return

All Stocks


18.1%

11.08%
75% Stocks/25% Bonds
14.3

10.94
50% Stocks/50% Bonds
11.0

10.60
25% Stocks/75% Bonds
9.0

10.05
ŠAll Bonds
9.1

9.32
Source: Ibbotson Associates series on large-cap stocks



All things considered, there is a lot to be said for a strategy of maintaining a fixed-weight portfolio with annual rebalancing as long as the stock portfolio is diversified across sectors. In investments, it pays to keep things simple.

Dr. Reichenstein, CFA, holds the Pat and Thomas R. Powers Chair in Investment Management in Baylor's Hankamer School of Business.
Are you looking for more News?