• Portfolio Strategies
  • A Balanced Approach: Less Risk, But Lower Potential Return

    by Stuart Ritter

    A Balanced Approach: Less Risk, But Lower Potential Return Splash image

    The annual return of the S&P 500 index has been 10% or higher in more than half the years from 1926 through 2010. However, in more than a quarter of the years for this period, the index delivered a negative return.

    But an allocation to bonds has tended to dampen the volatility of an all-stock portfolio—while only somewhat limiting positive outcomes.

    For example, a balanced portfolio, composed of 60% stocks and 40% bonds, delivered annual returns above 10% almost as frequently as the S&P 500, but provided negative returns in slightly fewer than a quarter of the years.

    As shown in Figure 1, the balanced portfolio’s annual returns were less widely dispersed from the stock market’s long-term average of 9.87%, as measured by the S&P 500.

    Over the entire period, the balanced portfolio’s annualized return was 8.52%, or 13.7% lower than that of the all-stock portfolio, but it displayed a 40% reduction in risk as measured by the difference in volatility for the two portfolios.

    Moreover, the balanced portfolio’s worst annual loss was 28% compared with 43% for the stock portfolio.

    While the degree of risk reduction is significant—and it may be very appealing for many investors—those investing for very long-term goals also should consider the potential trade-off in terms of the balanced portfolio’s record of lower returns.

    For example, a $10,000 initial investment in the balanced portfolio for five years would have yielded roughly $950 less, or 6% less, than the gains in the all-stock portfolio, assuming average returns were sustained.

    But the balanced portfolio’s historical record of having lost money less often may make this lower return an acceptable trade-off, particularly for those whose financial goals are not long term.

    However, over a period of 30 years, the balanced portfolio could provide $52,000 less, or almost 31% less, than the all-stock portfolio, assuming historical returns.

    An annualized return of 9.87% versus 8.52% doesn’t sound like that big of a difference. But compounded over time, it can add up.

    Stocks reflect the S&P 500 index and bonds reflect the Ibbotson Associates SBBI US Intermediate-Term Government Bond index. Source: T. Rowe Price, based on Ibbotson data.

    How Much Risk?

    So that begs the question: How should investors decide how much risk to take? T. Rowe Price advises investors to choose their investment allocations based primarily on the time horizons of their financial goals and personal circumstances as follows:

    When investing for shorter periods of time, investors should allocate more to bonds to dampen market risk. That decreases the chance of having a losing year or incurring substantial losses. Over shorter periods, investors may not end up giving up that much potential return using this more conservative strategy.

    In practice, a 60% stock/40% bond portfolio is appropriate for a medium-term horizon—five to 10 years away from a financial goal. Whether saving for a child’s education or for a down payment on a home, avoiding large potential losses when the money is needed is the determining factor.

    For financial goals with much longer time horizons, such as saving for retirement, a higher allocation to stocks may be needed—at least until investors approach their retirement date. With many years until they start withdrawing those assets, investors should try to look beyond periodic market downturns.

    Long-term investors can benefit from the greater growth potential that a larger allocation to stocks could provide, and they have the time to ride out the increased volatility this approach entails. Shorter-term investors need to protect themselves more from the possibility of short-term losses just when they need the money.

    Stuart Ritter a certified financial planner, is a vice president of T. Rowe Price Investment Services Inc.


    John from TX posted over 4 years ago:

    There is plenty of commentary demonstrating the risk dampening effect of bonds. That is because bonds increase in value when stocks decline largely because interest rates fall when the economy is suffering.

    However, my concern is going forward. With interest rates at historic (and probably unsustainable) lows, it seems that bond investing is much riskier today and over the course of the next decade. Stocks may or may not rise, but it seems that interest rates have only one way to go, which would cause bond values to decline, perhaps sharply. Just food for thought - is this commentary relevant considering the bond market of today?

    Michael from MD posted over 4 years ago:

    Great article...and a very timely insight from John in Texas....a resonse from Stuart Ritter would be appreciated. Thanks.

    Bernard from VA posted over 4 years ago:

    The proposition of 60% stocks and 40% bonds is incomplete. For example, if you are already retired and 70+ years old and have reached your goal of a significant portfolio and assets that at the present appear to be enough to last you for life, then a relevant factor to consider for your bond portfolio is duration. If you have bonds that mature in the next 5-15 years then you can plan on holding on to the bonds until maturity without much concern for the fluctuation in value. Therefore, the makeup of the 40% bond portfolio will be different for the 50 year old investor than it will be for the 70+ year old investor.

    Charles from IL posted over 4 years ago:

    John, here is Stuart Ritter's response (which we will publish in the January Journal):

    A couple of issues to keep in mind related to the reader's points about bonds and the economic environment:

    *Bond investors should consider total return, which reflects a bond’s yield as well as changes in price due to interest rate movements and changes in other risk factors.

    *If interest rates rise then total returns for high quality bonds would be negatively impacted by rising interest rates.

    *At the same time, if interest rates were to rise, perhaps in response to stronger than expected economic growth, then total returns for other types of bonds such as high yield or emerging market bonds would not be as materially impacted by rising interest rates as their yield spreads relative to high quality bonds would potentially compress in response to potentially improving economic growth prospects and the potential positive impact on credit quality.

    Therefore, a diversified fixed income portfolio can also potentially perform well under a broad range of economic scenarios, although possibly underperform US Treasury bonds in an environment of slowing economic growth and falling interest rates.

    It's important to keep the above in mind when considering the role bonds play in a portfolio. Stocks and bonds don't always move in opposite directions, and rarely by exactly the same amount. Historically, bonds have provided a lower average return with lower variability. Holding bonds in an otherwise pure stock portfolio has dampened the volatility an investor would otherwise experience – and this historical reality should still be taken into consideration when constructing a portfolio.

    -Charles Rotblut

    Cliff from NH posted over 4 years ago:

    Well written Stuart, and John from Texas, your points are well taken. I would say that trying to time either market, equity or fixed can be a futile exercise. Take a look at the decade of the fifties where interest rates remained exceptionally low. We're are currently into 3 years of exceptionally low rates, but that can extend a long time. In addition, depending on how you invest in fixed, i.e., corporate, treasury, global, high-yield, muni, there are always opportunities. The bond market is considerably larger than the equity market, and with good research or selecting a good fund manager, opportunities will always exist. Always select an allocation based on your own "peace-of-mind" gage, notwithstanding age, because investing is like clothing, not one size fits all.

    Christopher from MA posted over 4 years ago:

    In my opinion, investors should NOT adjust their stock/bond ratio based on their risk level. The ratio of stocks to bonds should be held in proportion to their total market capitalization. The investor should adjust their risk level by holding more or less cash. If an investor is very risk-tolerant, they can use leverage to achieve higher returns. This is the finding of the Capital Asset Pricing Model.

    Cliff from NH posted over 4 years ago:

    Christopher, your point is well taken, however CAPM does not take into account behavioral finance. All are individuals, all have a peace of mind investment gage. To place the remaining assets into cash allows for a (possible) substantial amount of assets to effectively lie dead. Graham even believed that non-enterprising investors should have a bond allocation. John Bogle's asset allocations are also based on a equities/fixed allocation (he uses the total bond mkt index). Remember capm does not purport to reduce systematic risk. To reduce systematic risk, we need lower correlating (typically, fixed, i. e. bonds) to non-correlating assets (alternative investments). Bogle might give the simple formula i.e take 100, subtract your age and that is the equity allocation recommended. Graham might say that a non-enterprising investor should have at all times at least 50% allocated to fixed, which includes bonds and cash. A guy like Rob Arnott might say using "tactical asset allocation" truly diversifies a portfolio and can substantially reduce systematic risk
    Roger Ibbotson has done an outstanding job compiling data, allocating various asset classes, mean returns and standard deviations. Although not necessarily predictive, it gives a clue within a certain confidence level as to how much variance or possible range of returns might be achieved around a given, expected mean.
    In short, one size does not fit all. All investors are intolerant to some degree of risk. I urge all to educate themselves as well as possible before committing money without understanding the potential risks.

    Ralph from TX posted over 4 years ago:

    A complicating factor is life span. The current life expectancy of 72-74 years includes everyone who died under 40yo. If these are removed the life expectancy goes up considerably. Therefore a 72yo who follows the dictum of "%bonds =age" could easily outlive the money.

    Cliff from NH posted over 4 years ago:

    All comments that I read are predictive, which in itself can be dangerous. Again, there is no investment worth peace of mind. The goal is to design a portfolio that in real dollars exceeds inflation, and one that keeps the investors "morale" within the design of the allocation. Yes, life expectancy is increasing, and it is an important variable in determining retirement needs analysis. One offset of this issue perhaps includes potential retirees working during the retirement years (we already see data pointing in that direction). Many of us, if healthy will choose to continue contributing within the work-force, perhaps to a lesser degree, perhaps not. Nothing works in a vacuum. Society, mores and expectations are certainly changing. Also, the dynamics of retirement and what retirement means are constantly changing. For those really interested in understanding many of these retirement issues, I would suggest reading the "Employee Benefit Research Institute" (EBRI) compilation of data. The website is www.erbi.org.
    Much of the information is enlightening and at times "eye-popping"

    James from OH posted over 4 years ago:

    I do not disagree with Mr. Ritter’s statements or conclusions. However, I think he has understated the impact of asset allocation on return for long term investors.

    In the article, he points out that with a $10,000 investment over 30 years, the balanced portfolio (which averaged 8.52% return per year) would have produced $50,000 less than the unbalanced portfolio (which averaged 9.87%). I agree with his numbers. But, suppose an investor had started with $100,000 (probably not an outlandishly high number for AAII members who probably are in their 50s with 30 years of investing ahead of them). In that case, the balanced portfolio would have produced $521,000 less - - - a huge amount by my standards.

    As an offset to such lower returns, Mr. Ritter points out that the balanced portfolio displayed a 40% reduction in risk and its biggest one year loss was 28%, compared to the unbalanced portfolio which lost 43% one year. I don’t know about you, but neither of those points offsets a shortfall of $521,000 in my mind!

    I agree with what the author said T. Rowe Price advisors recommend. That is, short term investors need to be quite concerned about high volatility. Long term investors should largely ignore volatility. - - - In my mind, the only reason for a long term investor to worry about high volatility is if he has trouble sleeping at night because of the ups and downs in the value of his portfolio.

    Comments by the other AAII members are insightful. I am quite in agreement with John from Texas’s concern about rising interest rates and, hence, lower bond prices. I would also add to the mix that many people in the investment world believe that inflation is eventually going to kick in, given what the federal government and Federal Reserve has done in the last couple of years to get us through the financial crisis that started at the end of 2008. - - - Mr. Ritter could be helpful here by sharing the results of the balanced and unbalanced portfolios during those period between 1926 and 2010 when interest rates were rising.

    Sidebar: Mr. Ritter says over the period from 1926 through 2010, the balanced portfolio reduced the risk by 40%. In their article that appeared in the May 2011 issue of the AAII Journal, Kinniry, Jaconetti, and Zilbering presented results of their asset allocation and rebalancing modeling from 1926 to 2009. The risk (as defined by standard deviation) was reduced from 14.4% with no asset allocation and no rebalancing down to about 12% with both. That’s a 16% reduction, materially lower than Ritter’s 40%. - - - What should we conclude from these two sets of results? That rebalancing is harmful to risk reduction?

    Continuing along that line, it would also be helpful if Mr. Ritter presented results with rebalancing.

    James from OH posted over 4 years ago:

    I put paragraph breaks and blank lines in my comments, but they never show up after being posted.

    How do I force a line break?

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