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Page 5 of 8
This chart compares the historical returns of U.S. stocks and bonds, net of inflation (real returns), over different holding periods or investment horizons from one year to 30 years. The dotted lines represent the average returns for stock and bonds for all periods and the solid ones show the bad outcomes (divider between the best 95 percent and the worst 5 percent). When you look at the simple average, stocks offered systematically higher real returns, even after the two major down markets of 2002 and 2008. These results for the U.S. markets are largely consistent with findings in other markets around the world over similarly long periods, even if the U.S. equity market has one of the highest returns, as highlighted by Dimson, Marsh and Staunton [2009].
However, when looking at downside risk, as measured by the worst 5 percent of returns, the picture is completely different. Equities were very volatile over a one-year horizon, while bonds were less so. Only cash provided more protection in extreme events. More generally, the downside risk was higher in the case of stocks for relatively short holding periods of up to five years. For longer investment horizons, the drawdown risk was not as significant, and in fact for horizons of more than 10 years, stocks even enjoyed a slight advantage.
Why is this particularly important for individual investors? Most retirement solutions offered to individuals today are trying to find optimal solutions for average investors, which is different than solving for the constraint of an individual retiring at a unique point in time. This is not surprising given that most research has been conducted in the context of vehicles such as defined benefit plans that pool assets and liabilities. Unfortunately, an individual in a defined contribution world does not benefit from pooling liabilities with others. An individual planning for retirement needs to have sufficient funds for his or her maximum life expectancy, not the average one. On the contrary, an insurance company providing an annuity service would be pooling the liabilities, allowing it to focus on the average life expectancy, since individual differences are canceled out at the aggregate level. Similarly, while the average investor will not retire in a catastrophic year since such years are not regular events, the prudent individual investor cannot rule out the possibility that he or she will retire in a year like 2008.
Segregation of assets and liabilities forces individual investors to put more emphasis on tail risk than pension funds with very long horizons. The optimal solution for an individual is therefore found in the context of the worst case scenarios, not the average ones. The logical consequence of this statement should lead to a dramatic change in the asset allocation of individual retirement products, such as target-date funds, toward less risky assets as retirement dates approach.
Toward Risk-Based Asset Allocations
Another reason why diversified portfolios did not offer as much downside protection as anticipated during the events of 2008 is that diversification strategies were often misapplied. In particular, it has become clear that the categorization of asset classes in a portfolio influences the approaches chosen for diversification. Many pension plans are still using a categorization of asset classes that groups assets into three buckets: equities, fixed income and alternatives. The category of alternatives includes private equity, private real estate, hedge funds, commodities and other real assets.
This segmentation reflects more the structure of asset management practices than the role that the assets are supposed to play in the portfolio, and that has led to some undesirable effects. Firstly, the fixed-income category has evolved to include a mix of low-risk government bonds with higher-yielding assets like corporate high-yield bonds and emerging markets bonds. The rationale for including these higher-risk fixed-income instruments in the fixed-income segment was that these assets were providing higher returns and diversification to the rest of the bond portfolio. That is true, but only if the bond portfolio is viewed in isolation. However, as we have seen in the first section, high-risk assets tend to be highly correlated in times of crisis. At the portfolio level, those risky fixed-income assets are in fact reducing the downside diversification that you expect from your allocation to bonds. Peters [2008] offers a particularly clear and elegant explanation of this phenomenon.
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