This is part 7 of my posts on passive investing for Europe based investors. After discussing historical returns for stocks and bonds it seems to be pretty obvious. You should allocate everything into bonds, they’re safe and stocks are risky! Or should you?
Financial definition of risk – do you care?
Mean returns of various assets are often compared to the distribution of their returns. If we consider actual numbers (more detail on this very good website on the topic), although US equities averaged about 10% returns per year, half of all returns were either worse than -1% or higher than 25%. In fact, 10% of all returns were worse than -20% or better than 39%.
Now US 10 year government bonds in comparison delivered on average 5% per year, with half of the returns between 0.84% and 8.46%. Of course this matters, if you have very cheap financing and you are willing to use leverage, i.e. investing using borrowed money, you can in theory multiply these returns by investing equivalent amount of risk as opposed to money terms. However, this is not an option for most investors.
Now say your investment horizon is 5 years as opposed to 1 year. Using Shiller’s data and including dividends, we get 50% of returns on US equities between 8% and 73% over any 5 year period. Over any 10 year period, we get to 50% of outcomes between 30% and 142% and 5% of worst outcomes below -20% (note the sample includes the Great Depression).
Small difference, huge impact
The relatively small difference in annualized returns translates into about 40 times higher value for the stocks portfolio. This can be even as much as 50 times depending on chosen periods/methodology (see similar results at mindfully investing). The graph below uses Shiller’s data.
Asset allocation implications
If I had a choice today for a 10-year purchase of a 10-year bond at whatever it is … or buying the S&P 500 and holding it for 10 years, I’d buy the S&P.Warren Buffet for CNBC
Taking compounding into account, the Warren Buffet’s quote above should not come as a surprise. Note that this is without even taking the current bond yield into account.
I will share some more thoughts on asset allocation in the next post.
Please let me know what you think in the comments below!