Advisor Blog

"Did your portfolio return 117% over the past 10 years?  Ours did..."  That's the subject line in the email that was sent to investors by Morningstar.  It's obviously designed to grab your attention and if you have even a vague idea of the return that the S&P 500 generated over that time period, it probably worked.

According to Morningstar, "The past 10 years have been, well, complicated (to say the least).  From a long, brutal recession and fitful recovery to markets driven by fear and uncertainty, it has been a real test of any investor's mettle... which makes the simplicity and success of our strategy all the sweeter... for our flagship newsletter, Morningstar StockInvestor." 

Morningstar goes on to explain that their "tortoise portfolio" returned 123.2% and their "hare portfolio" returned 109.7% for a combined 116.5% as compared to 42.8% for the S&P 500 over the time period of 6/18/2001 through 4/1/2012.  That's actually closer to 11 years than 10 years, but I suppose that wouldn't sound as good.  If we advertised our performance in this manner, we would be in violation of SEC rules.  But, since Morningstar isn't a Registered Investment Advisor, they aren't held to the same standards.  Ignoring this, though, the performance sounds impressive - particularly when compared to the S&P 500.  But, how much risk did the portfolio take to generate this return?  We don't know because there isn't a shred of data about risk included in the advertising - no measure of beta or standard deviation anywhere.  No information about risk-adjusted return (Sharpe ratio, Treynor ratio, etc) to be found.  To call this incomplete would be a charitable description.

OK, ignoring risk (like Morningstar did), what about the return?  The numbers certainly sound good.  So, let's compare it to something we know like, oh, say - the Talis 100 portfolio, our globally diversified equity portfolio built with DFA funds.  We can't quite match the odd time period that Morningstar chose (starting 6/18/2001), but we can look at both 6/1/2001 and 7/1/2001 through 4/1/2012 - close enough.  And those numbers (adjusted for the fund expense ratios and the highest advisory fee that we charge and subject to important disclosures found here) are 145.2% and 144.4%, respectively.  I think it's fair to say that's a significantly better result.  So, how much risk did we take to get there?  Unlike Morningstar, you can visit our website and compare the standard deviation of any of our portfolio models to appropriate benchmarks.

According to a research report published by Vanguard, recent stock market volatility is not unexpected when compared to previous time periods of significant macroeconomic events.

"Although the stock market volatility... appears extraordinary relative to the calm of the last year, [data] demonstrates that the levels of market variations today are, in fact, "ordinary" relative to the volatility of other periods characterized by major gobal macro events." state authors Francis M. Kinniry Jr., CFA, Todd Schlanger and Christopher B. Philips, CFA.

From July 1992 to August 2011, the S&P 500 Index moved an average of 0.7% per day.  The daily volatility spiked - or doubled - to 1.46% when significant global events occurred.  "As a result, we would argue that... volatility in equities, although high and painful to many investors, was not unexpected, given the market environment and the widespread repricing of risk.  Thus, in Vanguard's view, to cast the current environment as a 'new paradigm' of volatility is misleading."

The Vanguard report found that from August 5 (the day that S&P downgraded US Treasury debt, kicking off this period of volatility) to August 30, the S&P 500 Index moved an average of 2.5% per day.  We examined the September and October time period and found that the average daily volatility was 1.6% and 1.5% respectively.  It is not unusual for volatility to spike and slowly decay (statistically, it is serially autocorrelated). 

In 2008, we saw 23 days when the S&P 500 moved more than 4%.  This level of volatility occurred for seven days in 2009, no days in 2010, and has occurred six times, so far, in 2011.  Movement of 1% happened on 129 days in 2008, 108 days in 2009, 67 days in 2010, and 59 days in 2011 to date.

The Vanguard report looked at the volatility of two hypothetical balanced stock/bond portfolios - an 80% S&P 500/20% Barclays Aggregate Bond and a 40% S&P 500/60% Barclays Aggregate Bond.  As expected, in 2008 and 2011, the S&P 500 experienced "markedly more volatility than the two more conservative portfolios." and concluded that investors with balanced, diversified portfolios have faced much less aggregate volatility than the headlines would suggest.  We concur.

Finally, the authors note that "realized volatility is a critical factor in the equity risk premium (ERP), or the extra return demanded by investors for investing in stocks instead of less risky assets such as bonds or cash" and that "periods of heightened volatility or risk can actually increase the forward ERP."  This is, of course, consistent with the message that risk and return in capital markets are inevitably related.

Our portfolio model performance has been updated through June 30, 2011.  To view it, click here, read the disclosure, scroll to the bottom of the page, and click on the accept button.  The update shows model performance net of fund expenses and advisory fees for 1, 5, 10, and 20 year periods and for annual time periods.  It also shows 20 year standard deviation results for each portfolio.  Standard deviation is a common measure of portfolio risk as measured by the variability of portfolio return.

As a comparison, we show the results of benchmark indices, including the S&P 500, MSCI World ex-US, MSCI World Small Cap, MSCI World Value, Intermediate Bond, and 3 month US Treasury Bills.

It is axiomatic in the world of financial economics that, in capital markets, risk and return are always related.  In fact, you will often hear that in order to create a portfolio with a higher expected rate of return, one must take additional risk.  One of my friends, who is also a client, recently told me that this seemingly obvious statement is very confusing to a lot of people.  He asked me how this could be true when a comparing a poorly diversified portfolio with a well diversified one.  And, he has a point.

The statement assumes that idiosyncratic risk in the portfolio has already been diversified away.  After that, adding to expected return requires taking more market risk.  Understanding the difference between indiosyncratic (or non-systematic) risk and market (or systematic) risk is critical to understanding this concept.  And, unless you've taken some finance courses or you're a portfolio manager (not a product salesman at a brokerage firm), you may not fully understand this.

Idiosycnratic, or non-systematic risk is risk that can be diversified away in a portfolio.  This is risk associated with individual assets.  An example would be company risk associated with an individual stock position (think Enron, for example).  If you hold just a few stocks in your portfolio, this is very signficant.  If you hold a few thousand stocks, it is so insignificant that it's close to zero.  It has been "diversified away".  The Capital Asset Pricing Model (CAPM) for which Sharpe won the Nobel Prize tells us that investors are not compensated for taking diversifiable (idiosyncratic or non-systematic) risk.  In other words, investors are only compensated for bearing market risk.

Market risk is risk that cannot be diversified away.  Rational investors eliminate all diversifiable risk for which they should not expect to be compensated.  Now, we can examine the statement that higher expected returns require taking additional risk.  The assumption is that diversifiable risk has been taken out of the equation.  Thus, tilting a portfolio toward riskier asset classes like small cap or value stocks increases the expected rate of return.  Likewise, adding less risky assets such as bonds, to the portfolio will reduce the expected rate of return.  Of course, this also reduces the overall risk in the portfolio and is used to adjust the level of portfolio risk to a level that is suitable for a client's risk tolerance, capacity, and time horizon.

The concept is better explained by the statement that, in a properly diversified portfolio, additional expected return can only be achieved by taking additional market risk.