Investment risk and return - are you on the right track?

Dr Stephen Nash explains what happens when equities perform outside the average.

Equities are extremely volatile, and the following article argues that the return series for equities can be divided by two lines, or “tracks”, which divide the data into high, medium and low equity returns.

Interestingly, these “tracks” can then be used to contrast between asset class risk and return, as well as portfolio risk and return. In other words, we can use this division of data to show how much stability of return fixed income can bring to a portfolio.

While bond allocations give the same rough return around half the time, bonds increase certainty of return when equities “run off the tracks”.

Investment ‘tracks’

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If we look at the annual returns of equities and the other main investment asset classes, then we obtain the following time series of returns. (See Chart 1)

Given the extreme volatility of equity returns, it would be instructive to separate actual asset class returns into the following, based on the average and standard deviation of equity market returns:

• Asset class return above average plus half of a standard deviation of return (A), or the dark blue line in Chart 2, or what can be referred to as the “upside”
• Asset class return above average less half of a standard deviation of return (B), or the red line in Chart 2, or what can be referred to as the “downside”. Given that is where the blood has been spilt, it is appropriate that this line is red
• Asset class return between A and B; between the dark blue and the red lines, or what can be referred to as “inside” the two limits.

We can define the upper and lower boundaries, as the investment “tracks”, around which we will show that much “blood” has been spilt.

This division of the data leads to the following division of the occurrence of data, from 1991 to 2012, in terms of trading days, as shown in Chart 3.

Asset class returns and risk

Using the division of data in Chart 3, we can record the return of each asset class when equities are in each of the three areas: upside, inside, and downside.

So, for example, if annual equity return is above the average plus a half standard deviation, then we record the relevant asset class return and then derive average and volatility measures based on this record for the relevant asset class.

Applying this division of data, where annual returns are in one of the above areas, to all the asset classes, we can determine how each asset class performs under the different scenarios, and this is shown in Chart 4.

Note the relative stability of all the fixed income asset classes in Chart 4, compared to equities for all types of equity market performance.

In other words, when equities stray outside the “tracks”, returns can vary wildly; they are either great or ugly, where blood is spilt by the investor.

One would expect, from the above, that equity risk is going to be quite high. Such an explanation is fulfilled in Chart 5.

Notice, in particular, that once equity return steps out of the tracks, equity volatility spikes, so that means the certainty of return effectively collapses. Investors need little reminder, as this has been the case for some years.

If one combines the risk data in Chart 5 with the frequency data in Chart 3, then some interesting conclusions can be drawn.

For example, note that equity volatility is around 12 per cent, more than half of the time, so that investors should expect a 12 per cent variation from the average return most of the time.

This shows high volatility.

Hence, if equities record a negative 11 per cent average return in the “downside” area, that means one should expect a variation of 12 per cent around that average, or between 1 per cent (negative 11 per cent plus 12 per cent) for the year and negative (negative 11 per cent less 12 per cent) 23 per cent for the year. On the “upside”, the opposite is the case, with extreme high returns possible.

Portfolio returns and risk

Given the above, we can then calculate portfolio risk and return for each side of the tracks.

In particular, we compare the average self-managed super fund (SMSF) allocation, of 75 per cent equity and 25 per cent cash, to two alternative portfolio allocations:

• 25 per cent equities and 75 per cent fixed rate bonds
• 25 per cent equities and 75 per cent ILBs (inflation-linked bonds)

Notice how the two alternative allocations provide positive returns even in the “downside” equity area, while the current SMSF allocation fails to deliver positive returns.

Also, the “inside” area delivers much the same return for all allocations.

In other words, around half of the time, the bond allocations give roughly the same return as the typical equity allocation, while increasing the certainty of return dramatically, when equities “go off the rails”.

While the “downside” area delivers low average return even with bond allocations, the reason is mainly due to equity performance, as the “downside” area is full of ugly equity return data.

In the alternative, the bond allocations also capture some of the positive return in the “upside” area.

Chart 7 shows how portfolio risk more than doubles for the typical SMSF allocation, when we move outside the “tracks”, while the fixed income risk is much more stable.

If Charts 6 and 7 tell you nothing else, it is that the current SMSF allocation to equities cannot be relied upon to provide positive returns on average.

Whenever equities stray into downside territory, the average return of the SMSF allocation is negative on average, and can be significantly worse in any one year.

Either fixed income allocation gives average positive return, even when equities stray into the downside area.

When equities stay between the tracks, as we expect this year, all portfolios generate around 10 per cent, yet the risk in either fixed income portfolio allocation mentioned above is significantly lower than the current SMSF allocation. 

Conclusion

Investment risk should be taken when it is rewarded. However, SMSF allocation takes unrewarded risk, and suffers when equities slump, which has led to blood on the tracks for many investors.

Switching allocations toward fixed income, as suggested, ensures that returns are positive on average, even when equity returns are negative. 

Dr Stephen Nash is director for strategy and market development at Fixed Income Investment Group (FIIG).