Tuesday, 1 March 2011

Test Your Portfolio with Historical Investing Returns

Have you ever wondered what results different portfolio combinations might have realistically produced using, for instance, the asset categories in the All-in-One portfolio funds we recently reviewed and adjusting for inflation, currency fluctuations, time periods and fund expenses? The Stingy Investor website (a permanent link is in our blog sidebar) has generously posted two unique tools:
  • Periodic Table - annual index returns in Canadian dollars (i.e. adjusted for foreign exchange rates) from 1970 to 2010 in real inflation-adjusted or nominal terms for twelve asset classes ranging from fixed income through equity to gold
  • Asset Mixer - a modelling tool to build hypothetical portfolios using the same data; one can select time periods, asset classes and weights, real vs nominal returns, historical or randomized historic return sequence and a percentage annual withdrawal if desired e.g. to test if the portfolio would have survived during retirement. There is the ability to adjust for fund expenses, either with typical rates for ETFs or various high/medium/low cost mutual funds, or with one's own arbitrary expense rates (note that this is done by setting a negative number in the Alpha cell). The main limitations: no taxes on capital gains/dividend or other income are included (thus this model is most realistic within RRSPs or other registered accounts); rebalancing is inflexibly once per year; initial investment only, no regular monthly or yearly purchases can be modelled.
Lessons from the Periodic Table (using the real returns, since that is what matters most)
  • Asset class returns jump about enormously and unpredictably - They go from top to bottom year to year and decade to decade, or vice versa. They have winning or losing streaks. There is no asset class that is always near the top or the bottom. Investors trying to predict such moves are likely to have a very difficult job.
  • Almost every year several asset classes lose money - It is rare for every asset class to make money - in the 41 years since 1970 it has happened only once, in 1993. It has not happened yet for every asset class to lose money in a year, though 1973 and 1974 in the wake of the 1973 oil crisis came close, when only Gold came through, with 50+% returns. Gold also did very well in the huge equity down years of 2002 and 2008. As for 2008, the year doesn't look so bad across all asset classes with every fixed income category but real return bonds having positive returns. Those who believe that fixed income always makes money, whether it is bonds (cf 1994 and 1999) or cash-like T-bills (cf 2009 and 2010), need to revise their thinking.
  • Real return bonds can also lose money after inflation - Though they compensate for inflation, sometimes the change in real interest rates causes the principal/capital value of these bonds to fall, witness 2006-2008.
Lessons from the Asset Mixer
  • Costs matter - Take any portfolio and try out the Alpha options for ETFs, compared to average mutual fund with much higher costs. Higher costs means lower returns and the resulting end value can differ considerably. We tried the Simply Canadian model portfolio of 50% Canadian All-Bond and 50% Canadian TSX Equity for 1970 to 2010. Results: ETF expenses 0.3% on bonds, 0.25% on equity gave 5.049% compounded (geometric) return and $7535 end value, versus Average Fund expenses 1.4% on bonds, 1.7% on equity gave 3.8% return and only $4558 end value.
  • Diversification smooths the returns ride - Portfolios need to be the focus, not individual asset classes. While the Periodic Table shows that one or another asset class is down every year, what really matters is the overall total portfolio return. The extensive statistics shown for each run of the Asset Mixer confirm the stabilizing benefit of having a portfolio. The same Simple Canadian 50/50 portfolio had a yearly standard deviation (the standard measure of returns volatility) of only 9.4% and nine down years from 1970 to 2010 while a 100% TSX equity holding had a standard deviation of 16.8% and 13 down years. Equally telling, the worst down year of the 50/50 portfolio was the 17% drop in 1974 compared to minus 40% for the TSX equity in 1973 - more than double. For those concerned about sleeping or being spooked into selling out at the worst time, the portfolio wins decisively.
  • Diversification sometimes also brings returns benefits - If one then compares the Aggressive ETF portfolio (28% Canadian bonds and the rest split equally amongst Canadian, US and EAFE/Developed country equity) for the same time period, the TSX equity-only holding fares poorly. The portfolio compound return is 5.3%. That might not seem like much more than the 5.0% of the TSX but the end value of $8407 versus $7299 looks a lot more impressive. Meanwhile the portfolio risk is still less than the TSX - only 10 down years vs 13, 12.1% standard deviation vs 16.8% and a worst down year of 34% loss vs 40%.
  • Portfolios are nevertheless highly variable and regularly experience severe drops too - 2008 was not an exception in being a bad year, as the following chart we have created using data from Asset Mixer shows. The long term investor must expect some big drops and be willing to stick it out for the recovery. The good news our chart brings is that big up years happen regularly as well. It is also worth noting that there is seldom a year that is anything close to the long term average growth of 5%. It's a roller coaster, not a train.
We must be careful not to take precise figures too literally, for example the long run rates of return to be expected. Mark Twain's quip that "the past does not repeat itself, but it rhymes", reminds us of the limitations of any jump from past to future. Another key missing ingredient from the model is the lack of ability to account for regular payments instead of one lump sum invested at the beginning. The choice of start year and end year can also alter the comparative returns of different portfolios.

Nevertheless, these tools are worthwhile for experimentation and education. Stingy Investor Norm Rothery acknowledges the invaluable contribution of Norbert Schlenker of Libra Investment Management in compiling and making publicly available much of the data underlying the tools. To which we add a loud hear, hear to both men.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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