Risk vs. Reward: What's best for you?

One of the most important things we do for clients is make sure they have realistic expectations. In this article Paul Merriman draws on 36 years of data to explore the most fundamental equation of investing: the tradeoff of risk vs. reward.

Arguably the two most important articles online at FundAdvice.com are “The ultimate buy-and-hold strategy” and “Fine-tuning your asset allocation.” The first outlines the asset allocations I recommend for long-term buy-and-hold investors. The second shows how to adjust the fixed-income part of that allocation so each investor can “dial in” the right amount of risk.

At my company we often use the table from “Fine-tuning your asset allocation” when we work with clients.  I use it all the time in my workshops, because it helps me teach a lot of valuable lessons.

One of the most important ways we help clients is to make sure they have realistic expectations, and we use this table to do that. I think the table helps people prepare for what may lie ahead as they make some basic investment choices.

Airline passengers count on pilots and co-pilots to use extensive pre-flight tests, inspections and checklists to make sure their aircraft is ready to take off – and of course for the trip and landing. This is so basic that we take it for granted, and I’m glad we can.

Investors who put together a portfolio don’t usually think of themselves as passengers about to take a trip. But they should. The trip may be smooth or bumpy. The ride may meet all their expectations or be full of surprises. But there will be a ride, and I think investors need to do the equivalent of a pre-flight check to make sure they are on the proper flight, so to speak.  

GETTING RISK RIGHT

In the “Fine-tuning” article I pointed out some things I see in Table 1. Each column represents the same mix of equity asset classes (except for the Standard & Poor's 500 Index column at the right); but each column has a different percentage of fixed-income funds. That’s what this discussion (and this table) is all about: getting the right percentage of fixed-income funds. This is how you fine-tune your asset allocation and your level of risk.

(The equity asset classes used include U.S. large-cap stocks, U.S. large-cap value stocks, U.S. micro-cap stocks, U.S. small-cap value stocks, international large-cap stocks, international large-cap value stocks, international small-cap stocks, international small-cap value stocks and emerging markets stocks. These equity portfolios each contain more than 12,000 stocks, compared with 500 in the S&P 500 Index.)

Used correctly, this table should give you perspective and help you see one of the most fundamental relationships in investing, the link between risk and reward. Almost always, higher potential rewards are coupled with higher risks.

Notice that language. Rewards are potential. Risks are real.

SOME OTHER BASICS

Early in my workshops, I ask each participant to identify his or her primary goal as an investor. Is it to beat the market? Is it to achieve the highest return possible within their risk tolerance? Or is it to obtain the return they need at the lowest possible risk?

A few people always think they want to beat the market, which is usually defined as the Standard & Poor's 500 Index. But when I point out what that really means – for example that they would have felt completely successful if in 2002 they had lost 20 percent of their life savings – they find “beating the market” a little less exciting.

Most people want either the highest return possible within a certain level of risk or the lowest-risk way to achieve the return they need.

Table 1 lets you do that.

Each column of the table shows 36 years of results, from 1970 through 2005, of taking a given amount of risk. As you move to the right, the risk level increases; the returns do the same, except for the final column representing the S&P 500 Index as a benchmark.

At the bottom of each column are various measurements of risk. To return to the airline analogy, if each column represents a particular flight, the numbers at the bottom tell how smooth or how bumpy that flight would have been.

For example, the worst 12 months in the column with only 20 percent equity was a loss of 2.9 percent. That is a very smooth ride for a “flight” that lasted 36 years. When you increase the equity to 60 percent, the worst 12 months was a loss of 19.7 percent. That’s very, very different, though I believe that many investors could accept it. (The annualized returns are very different, too: 8.8 percent in one case vs. 11.6 percent in the other.)

It’s tempting to look at only the return of each column and forget the risks. But this is perhaps the biggest mistake that investors could make with this table.

If in advance you had the bottom numbers in each column (but not the year-by-year returns), you might be tempted to go for the all-equity portfolio for its annualized return of 14.1 percent.

However, as the table shows, at some point you would have experienced five straight years with a loss of nearly 10 percent. Maybe you think you have enough patience and faith to stick with this strategy in the face of such losses. But millions of investors do not have that. The majority of investors would bail out, very predictably at the wrong time, after losing money for so long while watching other investors count their gains from other assets.

WHAT’S YOUR GOAL?

In my workshops, I ask each participant to commit to one of the three basic objectives. Those who want to beat the market could have done so in this period with 60 to 100 percent equity portfolios.

Those who want the highest return within their risk tolerance must first determine the amount they are willing to lose without bailing out. I suggest using the worst-12-month figure for this. Scan across that line to find a column that lost the amount you are willing to lose. For instance, if your loss tolerance is 20 percent, the 60-percent equity column is just about right for you.

Those who want the lowest-risk way to achieve the return they need should scan the annual return line to find the column that fills the bill. If you can meet your needs with a return of 10 percent, for example, the 40-percent equity column gives you a good shot at that with a fairly moderate level of risk.

LOOKING AT THE FUTURE

The weakness of this table is that it’s based on performance over the previous 36 years. It doesn’t tell us what future returns and risks will be. Will the next 36 years be similar? There’s no way to know, but I’ll give you my best thinking on that question.

I believe that the risk characteristics in each column will be more reliable in the future than the return characteristics. In practical terms, I think that means you should give more credence to the worst-period numbers than to the annual returns.

For example, I’m not at all sure that a 70-percent equity portfolio will produce a long-term annual return of 12.3 percent. But I’m pretty sure that any investor in such a portfolio should be prepared to withstand a 12-month loss in the neighborhood of 25 percent.

Therefore, I think this table may be more valuable for choosing on the basis of risk than for choosing on the basis of return.

LESSONS FROM THIS TABLE

•    Diversify your equity investments. Look at the two right-hand columns and you’ll see that the diversified equity portfolio had three extra percentage points of annual return. Over decades, that difference is huge. Yet this return was achieved at lower risk. Whether they made up 10 percent or 100 percent of a portfolio, properly diversified equity investments in this 36 years worked harder for investors than the S&P 500 Index. I don’t think that will change in the future.

•    An all-equity portfolio is probably too risky.  The all-equity and S&P 500 Index columns exposed investors to 12-month losses of 35.1 percent and 38.9 percent, respectively. Less than 5 percent of the people I talk with in my workshops say they are willing to lose more than 30 percent in a 12-month period. I believe almost everybody needs some fixed-income funds to tone things down.

•    An all-fixed-income portfolio is more risky than it needs to be. This is counter-intuitive, I know. Compare the first two columns and you’ll see that adding just 10 percent in equities improved the annual return by 11 percent – from 7.3 percent to 8.1 percent – while it reduced risk by every measure except standard deviation, which is of interest mostly to statisticians. Moving from zero equities to 20 percent equities improved the return by more than 20 percent –from 7.3 percent to 8.8 percent – while subjecting investors to a virtually identical worst-12-months loss.

•    The middle may be the sweet spot. Most retirees we work with have indicated they are willing to accept a worst-12-months loss of 10 to 20 percent. That suggests a portfolio with 40 percent to 60 percent in equities would be suitable for many retired investors. However, each of those portfolios experienced losses that extended for 36 months, long enough to test many investors’ patience.

•    It’s easy to dial in some stability. Adding fixed-income to a portfolio consistently reduced 12-month losses. Moving from an 80 percent equity portfolio to a 60 percent equity portfolio cut the 12-month loss in this table by almost 30 percent.

•    Risk disappears faster than return. The annual return of the 60 percent equity portfolio was 11.6 percent, or 90 percent as much as the return of the 80 percent equity portfolio. By giving up only 10 percent of the return, an investor achieved a nearly 30 percent reduction in risk. That is what I call a good deal. You can find similar results from other comparisons.

•    Five years is a long time to be “under water.” The last line in each column shows the worst five-year period. Though this return is positive for most of the columns, the gains decline as more equity is added. An 80-percent equity portfolio would have left a small (1.9 percent) deficit after one five-year stretch; the S&P 500 Index’s worst five years was much worse.

•    The return of “the market” was available at less than half the risk. The 50 percent equity portfolio has virtually the same return as the unmanaged S&P 500 Index. Yet the 50 percent equity portfolio reduced the one-month risk by 62 percent, the 12-month risk by 60 percent and the 36-month risk by 90 percent.

•    One period doesn’t predict the next. Every one of these portfolios did very well from 1995 through 1999. Many investors (as well as analysts, commentators and advisors) misunderstood this and loaded up on more equities, ignoring risks. The period from 2000 through 2002 was a rude awakening for many people who lost substantial parts of their life savings.

•    Eager investors can be blindsided by short-term performance.  Many people poured money into equities in late 1999 and early 2000, thinking they had discovered financial nirvana. They were wrong. The S&P 500 Index, which gained 251 percent from 1995 through 1999, lost 37.6 percent (cumulative) over the following three years. This didn’t ruin investors who had been in the index the full eight years. But those who jumped in close to the market’s peak were hammered. Returning to the pre-flight analogy, this is the equivalent of simply assuming that the weather will keep doing what it has been doing and ignoring the possibility of changing conditions.

•    Conservative investors can be blindsided, too. From 1980 through 1986, short-term bonds provided returns that were historically incredible. The fixed-income portfolio in the table had a cumulative return of 155 percent, equivalent to an annualized return of 14.3 percent. That is more than five times the annualized return of one-month Treasury bills from 1926 through 1979. Risk-averse investors who concluded that short-term bonds were all they needed might have had a rude awakening when, in the following eight years, 1987 through 1994, the fixed-income portfolio in the table had only one double-digit year (1991) and showed a loss in 1994.

•    Market rebounds after major declines have been abnormally high. After the awful bear market of 1973-74, the all-equity portfolio compounded at a rate of 28.2 percent for six years. While the years 2003 through 2005 may seem like a “return to normalcy” after the recent bear market, the all-equity portfolio’s 27.1 percent annual return in 2003 through 2005 is far above any norm.

•    The 50-percent equity portfolio made many investors happy in 2000-2002. By itself, this portfolio’s cumulative gain of just under 1 percent in those three years does not seem like much. But considering that millions of investors lost much of their life savings in those three years, a gain of any magnitude could start to look inviting – as it did to many investors we know whose portfolios were properly diversified. However, this portfolio still can lose. In the bear market of 1973 and 1974, it had a cumulative loss of 16.2 percent. The 2000-2002 bear market was unusual because several asset classes (international stocks, small-cap stocks and value stocks) did relatively well even as much of the market was taking a bath.

The figures in Table 1 don’t show the potentially devastating effects of inflation. You will find this data in Table 2. Except for the additional column on the right labeled “Real inflation,” this table is the same as Table 1, with one mighty difference: All the return figures are adjusted for actual inflation.

You will see some enormous one-year returns in Table 2. For example, look at returns across the board in 1985 and 1986.

But individual returns don’t tell the story well. The bottom line, showing each portfolio’s annual return after inflation, is sobering. In order to achieve a “real” return of 9.1 percent, investors had to have a well-diversified all-equity portfolio. While that portfolio had a 47-percent real gain in 2003, it lost nearly 55 percent of its real value in 1973 and 1974.

You might also notice that real inflation hit double digits during three years: 1974, 1979 and 1980. Many young investors won’t recall, as we do, the days when home buyers took out 30-year fixed-rate mortgages at rates of more than 18 percent and when savings banks advertised 30-month CDs that paid 16.5 percent.

The good news about this table is that every investment strategy shown here produced a real return higher than inflation over this 36 years. And as you would expect, that return increased with each 10 percent addition of equities (except of course for the S&P 500 Index).

The bad news is that  inflation erodes purchasing power invisibly but relentlessly. Anybody who counts on a fixed income for retirement can count on a declining standard of living.

Imagine that today you won an unusual lottery that promised to pay you $100,000 a year for the rest of your life – tax free. What a deal! For most people, this would make a very comfortable retirement income. Now imagine that you quit your job tomorrow and decided to live it up on your winnings.

But now think what would happen if inflation, starting the first year you received the income, were the same as it was every year from 1970 onward.

In that scenario, after only five years your $100,000 annual income would have only $68,000 in today’s purchasing power. The great life you thought was yours would be a bit out of reach. After 10 years, you would have only $42,000 of your initial purchasing power and you would certainly be disillusioned by your great good fortune.

A retiree in good health has an excellent chance of living at least 15 years. In your (imaginary) case, your 15th annual $100,000 check would buy less than a third of what the first one bought : $32,400, to be exact. By this time you would have to find other income or kiss the good life good-bye.

Granted, 1970 through 1984 were years of abnormally high inflation. But that inflation was very real, and many people were hurt badly. Nobody knows what future inflation will be, but it certainly could heat up again.

The biggest thing I hope you will take from Table 2 is that there’s no hiding from inflation. The only defense I know is owning equity investments.

I believe virtually every individual investor should have some equities in his or her portfolio. Think of it as an essential item on your pre-flight checklist.

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DISCLOSURE: The returns for the portfolios in Tables 1 and 2 represent investments made in a group of asset classes and asset class funds managed by Dimensional Fund Advisors and not available to the public except through registered investment advisors. Such advisors customarily charge management fees. Accordingly, we have assumed a 1 percent annual management fee in compiling the tables (except for the unmanaged S&P 500 Index).