How much risk should you take?

Historical returns can help guide strategic asset allocation

"Past performance is not a reliable indicator of future performance." This boilerplate warning slapped on every key investor document is a reminder that investing always involves risk and that past returns can’t just be projected to continue uninterrupted. 

But while history doesn’t repeat, we know that it often rhymes. We know that past returns contain information about risk and can help us make strategic portfolio decisions – just as meteorological data tells us something about our country’s climate even though we can’t accurately forecast next week’s weather. 

Long-term data helps us tease out the behaviours of asset classes and can be used to assess the balance of risk and return in model portfolios. 

Armed with our working assumptions, we can use this knowledge to customise our portfolios to suit our expected returns, individual risk tolerance and time horizon. 

 

Historical performance comparisons reveal a great deal

We can learn a lot about past asset allocation sweet spots by matching up high-risk and low-risk portfolios against each other. 

You can see how this plays out when we drill into the performance of a 100% global equity portfolio based on the MSCI World Index versus a 100% German government bond portfolio. 
 
Our comparison assumes:
  When we run the numbers, the simulation highlights sharp differences in volatility and performance between equities and bonds:

 

Annual return on a bond-only portfolio from 2000 to 2019

 

Equity allocation of 0%

Equity allocation of 0%
Source: justETF Research; as of 31/01/2020

  

Equity allocation of 100%

Equity allocation of 100%
Source: justETF Research; as of 31/01/2020

Bonds were our steady Eddies during the period. They provided moderate returns even in times of crisis, while the equity portfolio was highly volatile and wracked by violent downswings. 

Despite the drama, the equity portfolio still notched an annualised return of 4.5% versus 4.1% for the bond portfolio. 

That’s even more impressive when you consider that equities cratered for the first three years in a row and were hit by two historic crashes within the space of a decade - the bursting of the dot-com bubble and the Global Financial Crisis. 

The tale of the ticker tape also illustrates how important the holding period is to capitalise on the long-term performance of equities. 

The equity portfolio inflicted negative returns initially but made strong gains in later years that ultimately smoothed out the annualised return over two decades. 

This pattern also traces the fundamental relationship between risk and reward. To reap the higher expected returns of equities you must deal with periods of wild volatility. 

 

Asset allocation – a free lunch

They say that ‘asset allocation is the only free lunch in investing,’ and our next table shows you why. 

This time we compare the annualised return and maximum drawdown for 11 portfolios with equity allocations ranging from 0% to 100%.  

 

Simulation of annual return from 2000 to 2019 for various equity allocations with a risk of 0 to 100%

Equity allocation   0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Annualised return   4.1% 4.3% 4.5% 4.6% 4.8% 4.8% 4.9% 4.9% 4.8% 4.7% 4.5%
Maximum drawdown   -4.3% -3.0% -3.9% -9.0% -15.3% -21.3% -28.4% -35.1% -41.3% -47.1% -53.7%
Best year   10.1% 8.1% 9.1% 10.3% 13.3% 16.3% 19.4% 22.4% 25.5% 28.5% 31.5%
Worst year   -1.0% 0.1% 0.3% -3.5% -8.1% -12.6% -17.2% -21.7% -26.3% -30.8% -35.4%
Source: justETF Research; as of 31/01/2020
 
  • Maximum drawdown is defined as the largest loss within a single calendar year.
  • Diversified equity: bond portfolios are rebalanced annually. 
Our tip: You can also see this comparison in our Strategy Builder.
Incredibly, the best performing portfolios during this period contained only 60% and 70% equities. These two portfolios delivered an annualised return of 4.9% that comfortably beat the 4.5% return of the 100% equities portfolio and the 4.1% of the 100% bonds portfolio. 

What about the free lunch? Well, both those portfolios produced superior returns while exposing investors to less volatility than the riskier equity portfolios. 

The 60% equity portfolio returned 4.9% versus 4.5% for the 100% equity portfolio, and yet:
 
  • The maximum drawdown was -28% versus -54%.
  • The worst calendar year return was -17% versus -35%. 
Simply put you got more gain for much less pain by diversifying across equities and bonds versus banking everything on 100% equities. 

The left-hand side of the table also shows how low-risk portfolios can sometimes deliver much of the upside while protecting you from the worst of the downside. For example:
  
  • The 10% equity portfolio scored a 4.3% annualised return in exchange for a -3% maximum drawdown. 
  • The 20% equity portfolio scored a 4.5% annualised return in exchange for a -3.9% maximum drawdown. 
Both portfolios outperformed the 100% bond portfolio which registered a 4.1% annualised return and a -4.3% maximum drawdown. 

The 10% and 20% equity portfolios didn’t even suffer a single calendar year of negative growth. The worst annual return of the two portfolios was 0.1% and 0.3% respectively. 

Neither of these portfolios would have had you popping the champagne corks at year-end either. They delivered the weakest ‘best year’ returns in the table, coming in at 8.1% and 9.1% respectively. 

Ultimately, the performance of the 10% and 20% equity portfolios was characterised by relatively low volatility between 2000 and 2019. 

Contrast that with the Jekyll and Hyde performance of the 100% equities portfolio which swung from a ‘best year’ of 31.5% to a ‘worst year’ of -35.4%. 

While our simulation is only a snapshot from a deeper historical record, it reveals patterns that repeat time and again:
 
  • Diversification across equities and bonds typically provides a better risk-reward ratio than investing 100% in either asset class alone. 
  • Equities provide handsome returns during boom times. 
  • Bonds can cushion losses during downturns.
  • Diversified portfolios can benefit from rebalancing between asset classes.
 

The rebalancing bonus

Rebalancing played a decisive role in the outperformance of 60% and 70% equity portfolios. 

You can see this by comparing the results of our portfolios with and without rebalancing. 

 

With and without rebalancing (annualised returns 2000 - 2019) 

Equity allocation   0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
With rebalancing   4.1% 4.3% 4.5% 4.6% 4.8% 4.8% 4.9% 4.9% 4.8% 4.7% 4.5%
Without rebalancing   4.1% 4.1% 4.2% 4.2% 4.3% 4.3% 4.4% 4.4% 4.5% 4.5% 4.5%
Rebalancing bonus   0.0% 0.2% 0.3% 0.4% 0.5% 0.5% 0.5% 0.5% 0.4% 0.2% 0.0%
Source: justETF Research; as of 31/01/2020
 
  • Rebalancing costs not included. An actual bonus would have been lower in practice. 
  • 100% equities and 100% bond portfolios are not rebalanced.
The annualised rebalancing bonus was a staggering 0.5% across the board for the 40% to 70% equity portfolios. Every diversified portfolio benefitted from a rebalancing bonus over the 20-year period. 

The equity allocation of each diversified portfolio shrank when the dot-com bubble burst. Without annual rebalancing, equities weren’t brought back to full strength within the portfolio and so growth was muted when the asset class rebounded in subsequent years. 

For example, the equity allocation of the 60% portfolio declined to a low of 32% without annual rebalancing. Thus the portfolio drifted into a completely different risk profile from the one originally intended and didn’t perform as might be expected over the full period. 

That goes to show just how important it is to manage your portfolio’s risk profile via rebalancing, regardless of any performance bonus that may occur over time. 

 

Asset allocation history lesson

This is a relatively simple simulation but it shows we can learn a lot from history. By observing asset class behaviour across the years, we can draw empirical conclusions about the general characteristics of our investments. From that vantage point, we can then make more informed decisions about how to weight our portfolios to suit our personal risk tolerance and expected return requirements. 

Find out more in our beginners guide to portfolio strategies.
 
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