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Wednesday, March 4, 2015

The Real World Isn't Always the Way It is in the Textbook...Especially If it is A Finance Textbook

I have been doing some research on updated data and the risk return of various asset allocations starting with a simple mix of the total world stock index and the total US bond index ( I am not a fan of non US bonds)

The textbook picture of what a portfolio risk and return should look like when you change the stock bond mix in a portfolio should be familiar to anyone that has taken a basic finance class or read a finance book. Increasing the stock allocation increases the return of a portfolio and raises the risk (measured as standard deviation)

I doubt there is a finance book published anywhere in the world that doesnt include this graph.

But when I ran various mixes of  the total international stock index and the US aggregate bond index here is what I got. The numbers in the key at the right are the % stocks in the allocation.

Below  is some more data in table form with returns and standard deviation. You can see that almost all time periods as you increase the allocation of stocks the increased return is not nearly as great as the increase in standard deviation. For example looking at ten year returns an 80% stock allocation gives an annual return of 6.58%  a standard deviation of 12.3 reducing the stock allocation to 60% drops the return a very small amount to 6.32% but the standard deviation falls quite a bit down to 9.43.

In other words raising the stock allocation from 60% to 80%  an investor is taking alot more risk (as measured by standard deviation) in exchange for a very small increase in return.

I ran the same exercise using only US stocks the results were a bit closer to the anticipated increase in return per unit of risk but nowhere near as large as shown in that textbook graph. Numbers at right refer to the % of stocks i,e, green is 50% US stocks 50% US total bond

 And once again as you can see in the table..not alot of increase in return relative to the increase in risk as you increase the stock allocation

Not exactly what the Dr. (the one with the Finance PhD ordered)

Obviously this raises some very interesting questions....

What implications does this have for your choice of  stock/bond mix ?...that will be the subject on the next blog entry on this subject .

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