January 5, 2009
Risk-reward History
To add further perspective, the following table shows the history of risk and return for stocks (S&P500), bonds (Citigroup High Grade), T-bills and inflation. There are many lessons in this table, so it’s worth your time and effort to review these results. For example, here are a few of the lessons:
- The standard deviation of monthly bond returns in 2008 (22.48) exceeded that of stocks (20.86), camouflaging the huge daily volatility in the stock market
- Bonds were more “efficient”, delivering more returns per unit of risk, than stocks in the first 41 years, but they have been about as efficient in the most recent 42 years. The Sharpe ratio for bonds is .69 versus .36 for stocks in the first 41 years, but the Sharpe ratio for both is about the same in the more recent 42 years.
- The past decade has been the worst for stocks across the past eight consecutive 10-year periods.
- Average inflation in the past 42 years has been three times that of the previous 41 years.
Risk-return history for Periods Ending December 31, 2008
stocks bonds t-bills cpi --------------------- --------------------- -------------- -------------- RETURN STNDEV SHARPE RETURN STNDEV SHARPE RETURN STNDEV RETURN STNDEV ------ ------ ------ ------ ------ ------ ------ ------ ------ ------ 2008-2008( 1 YRS) -37.22 20.86 -1.84 9.28 22.48 .33 1.70 .23 .66 3.03 __________________________________________________________________________________________________
1926-2008(83 YRS) 9.62 19.17 .29 6.15 7.27 .32 3.75 .88 3.07 1.86 __________________________________________________________________________________________________
1926-1966(41 YRS) 9.88 22.49 .36 4.43 3.98 .69 1.59 .42 1.54 2.27
1967-2008(42 YRS) 9.36 15.27 .21 7.85 9.40 .20 5.90 .80 4.58 1.20 __________________________________________________________________________________________________
1929-1938(10 YRS) -.89 37.95 -.05 7.93 4.65 1.45 1.02 .43 -1.95 2.55 1939-1948(10 YRS) 7.26 17.98 .39 3.58 2.16 1.50 .30 .08 5.56 2.94 1949-1958(10 YRS) 20.06 11.98 1.50 2.38 5.40 .13 1.68 .21 1.86 1.33 1959-1968(10 YRS) 10.00 11.64 .54 2.35 4.30 -.26 3.52 .29 2.07 .65 1969-1978(10 YRS) 3.17 15.91 -.17 5.79 7.90 -.02 5.94 .42 6.67 .99 1979-1988(10 YRS) 16.31 16.46 .40 10.85 13.14 .12 9.15 .82 5.92 1.37 1989-1998(10 YRS) 19.19 13.40 .98 9.89 5.68 .74 5.49 .52 3.22 .62 1999-2008(10 YRS) -1.39 15.17 -.30 6.85 9.64 .35 3.36 .51 2.71 1.38
Conclusion
These have been trying times, and may be a harbinger of more to come. As long as we’re paying the price, we might as well learn as much as we can from the lessons of these markets.
Here are a few lessons from this decrepit decade that can help us going forward:
- Investors are entitled to be concerned about recent capital market behavior. It’s been awful. “Staying the course” just hasn’t cut it, and might not going forward. But there’s a penalty for us all running to the door at the same time. The biggest risk we face is a panic-induced Pogo predicament: “We have met the enemy and they are us.” These are very tough decisions.
- Moving to certain styles, sectors or countries may help defend but hedging has worked best. Of course, investors can hedge on their own through the use of derivatives, or moving to cash.
- This is a good time to stress test managers for skill. You know that stuff about what the tough do when the going gets tough. But it is absolutely critical that the benchmark is accurate. Some will get fired for the wrong reasons, and then their replacements will get hired for the wrong reasons too. Clients need to know what a “fair” loss should be, given what the manager does. Hint: off-the-shelf indexes only work on index huggers.
- Selecting target date funds is currently problematic because the target date industry has entered into a performance race, and is exposing investors to too much risk, especially near the target date. The timing of these moves to higher risk was bad for investors, and it will be even worse if we don’t learn from this lesson: target date funds should defend better near the target date.
I am as challenged by these markets as the rest of us. Global stock markets plummeted when the bailout plan was not approved and when it was approved. Munis yield more than taxables. Gold goes down with everything else. Finance outperforms. TIPS tank. It’s like the god of random punishments is toying with us. There are opportunities in these dislocations, but they’re not for the squeamish or the amateur. I foresee high inflation in the not-too-distant future. We’ve been spending beyond our means for a long time. Inflation benefits debtors, the biggest of which is the US government, and this debtor has the ability to print money.
APPENDIX: Surz Styles
Style groupings are based on data provided by Compustat. Two security databases are used. The U.S. database covers more than 6000 firms, with total capitalization exceeding $18 trillion. The non-U.S. database coverage exceeds 15,000 firms, 20 countries, and $31 trillion -- substantially broader than EAFE.
To construct style groupings, we first break the Compustat database for the region into size groups based on market capitalization, calculated by multiplying shares outstanding by price per share. There are 3 regions maintained in our system: U.S., Foreign and Global. Beginning with the largest capitalization company, we add companies until 65% of the entire capitalization of the region is covered. This group of stocks is then categorized as "large cap" (capitalization). There are generally about 200 companies in this group for U.S., 800 for Foreign, and 1000 for Global. The second size group represents the next 25% of market capitalization and is called "mid cap". There are generally about 1000 companies in this group for U.S., 2700 for Foreign, and 3500 for Global. Finally, the bottom 10% is called "small cap". There are generally 5000 U.S. securities in this group, 10,000 Foreign, and 15,000 Global.
Then, within each size group, a further breakout is made on the basis of orientation. Value, core, and growth stock groupings within each size category are defined by establishing an aggressiveness measure. Aggressiveness is a proprietary measure that combines dividend yield and price/earnings ratio. The top 40% (by count) of stocks in aggressiveness are designated as "growth," while the bottom 40% are called "value," with the 20% in the middle falling into "core."
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