Younger investors should be taking on the most risk. Other in- vestors should be scaling up their risk level, almost no matter what age they are.
We are not asking you to walk the risk plank. We are not say- ing that you have to take all your money from a safer place and move it to a riskier place. We do not want you to have night- mares.
But you have to take a first step. Then, over time, you can learn to adjust your portfolio, not only to take on more risk, but also to respond to changes in the market environment.
If you are very conservative, with most of your money in Treasury securities and money-market funds, your first move is to shift money into investment-grade corporate bonds, which have higher yields than Treasury securities and money-market funds. Then you could shift some of your money into stocks, know- ing that you intend to keep it there for the long term, at least 10 years.
If you are already much more adventurous and have a lot of your portfolio in stocks, you can add risk by changing your mix of stocks. For example, you can move into smaller com- pany stocks—what are called small-capitalization or small-cap stocks.
A bolder step is to invest abroad. To this end you can add a lot of risk by moving to emerging markets, the growing stock markets in developing nations.
How much do these shifts in risk help you? Let’s take a look.
Remember that the historical data used here is to give you a way to compare the risk and return trade-offs of the various invest- ment categories we are describing. These compound annual rates
of return do not tell you what you will earn in the future. They are only an indication of the difference in returns possible for dif- ferent levels of risk.
Also remember that we believe that the returns from both the stock market and the bond market will be lower in the years ahead. So these historical returns are even less likely to be repeated.
Risk here is measured by what economists call the standard deviation of annual returns. The higher this number, the riskier the investment because the assets chosen have a wider range of returns, both positive and negative, over time.
In the 81 years through 2006, 30-day Treasury bills have been the safest place to be, as can be seen in Table 1.2. Their risk mea- sure—their standard deviation—is way down at 3.1. These Trea- sury bills have produced a loss in only one year, in 1938. But their compound annual rate of return over those 81 years is just 3.7 per- cent, according to Ibbotson Associates, a Morningstar company.3
Even a relatively small increase in risk, however, can improve
TABLE 1.2 Getting More Return for More Risk: Where to Find It Compound Number Number
Years Annual of of
Through Rate of Standard Positive Negative 2006 Return Deviation Years Years
S&P 500 stock index 81 10.4% 20.1 58 23
U.S. small-cap stocks 81 12.7% 32.7 57 24
U.S. 30-day Treasury bill 81 3.7% 3.1 80 1
MSCI EAFE Index 37 11.6% 21.9 27 10
Goldman Sachs Commodity Index 37 11.5% 24.1 28 9
Lehman U.S. Aggregate Index 31 8.6% 7.4 29 2
Lehman High-Yield Index 23 9.8% 12.3 19 4
MSCI Emerging Market Index 19 15.2% 33.6 11 8
JPMorgan EMBI Global Index 13 10.9% 14.8 11 2
Source:Ibbotson Associates.
Data from Federal Reserve, Goldman Sachs, JP Morgan, Lehman Brothers, MSCI, Standard
& Poor’s.
the outlook for returns. A move from the safest corner of the Treasury market to a mix of Treasury securities, from bills to bonds, and the addition of investment-grade corporate bonds and securities backed by mortgages raises the compound annual re- turn over the past 31 years to 8.6 percent. The risk factor is 7.4, more than twice the risk of the safest of the safe, Treasury bills. In those 31 years, there was a loss in only two years.
Your new portfolio would look like the composition of the Lehman Brothers U.S. Aggregate Index,4with 40 percent in mort- gage-backed and other so-called securitized securities, 25 percent in Treasury securities, almost 20 percent in investment-grade cor- porate bonds, and 15 percent in other government-related securi- ties, including the so-called agency bonds issued by the likes of Fannie Mae. If you decreased the Treasury portion and just moved the money into corporate bonds, for example, your risk and potential return would rise a little.
With interest rates much lower than they have been and, as we warned early in this chapter, likely to go lower, investors can- not expect to receive the 8.6 percent compound annual return of the past for this portfolio based on the Lehman Aggregate. But this portfolio is still going to be better than just staying in Trea- sury securities. In the five years through 2006, the compound an- nual return for a portfolio invested along the lines of the Lehman Aggregate was 5.1 percent, compared to 4.6 percent for a portfo- lio of just Treasury securities, according to Lehman Brothers.
That may not sound like much of a difference, but the Lehman Aggregate portfolio doubles in 14 years, more than a year before the Treasury portfolio.
To get more risk out of the bond market, investors can choose high-yield or so-called junk bonds. These are corporate bonds that are rated below investment grade, which means there is a much greater chance that the company that issued them will de- fault on its payments of principal and interest. But these bonds have become a popular addition to many portfolios because of the much higher potential yields they offer compared to Treasury securities and investment-grade corporate bonds.
In the five years through 2006, the Lehman Brothers High- Yield Index had a compound annual return of 10.2 percent, twice the return from the Lehman Aggregate portfolio over that period.
Since 1984, the compound annual return for high-yield bonds has been 9.8 percent, but their risk level is a standard deviation of 12.3, according to Ibbotson Associates, nearly twice that of the Lehman Aggregate portfolio.
But the big jump in risk—and return—is going from bonds into stocks. The compound annual return from the Standard &
Poor’s 500 stock index over the past 81 years is 10.4 percent,5 which is quite acceptable. It means that a person’s portfolio would take just seven years to double in value, which is a lot faster pace than the bond portfolio offers. While lower stock returns will make portfolio doubling take longer in the years ahead, the poten- tial rate for stocks will still be a lot faster than for bonds.
The price is higher risk, with the standard deviation for the S&P 500 at 20.1, which is more than six times the risk of Trea- sury bills. And in 23 of the 81 years of history, the S&P 500 had a loss.
To go even further out on the risk plank, investors could choose smaller company stocks. These are companies that you will not find in the Standard & Poor’s 500 stock index or in the Dow Jones Industrial Average. They are generally relatively new firms and often do not yet have a steady stream of earnings. Some do well; some do not. Some fail. That adds to their risk, but that is what also makes their potential returns higher. They are called small caps in Wall Street jargon, for small capitalization. A com- pany’s capitalization is its stock price times the number of shares outstanding.
The risk barometer for smaller company stocks is at 32.7, more than 10 times that of Treasury bills. And in 24 of the past 81 years, smaller company stocks had a loss. But their compound annual return over those 81 years is 12.7 percent.
The nicest blend of greater risk and bigger returns is in the stock and bond markets outside of the United States. We will be calling this the international part of your portfolio, because that
coincides with the terminology in mutual funds, where a fund that is called international invests most of its money outside of the United States. A global mutual fund, in contrast, can invest anywhere, which means it could have most of its money in the United States, despite the title.
In the developed stock markets abroad—from London to Tokyo—investors have gotten a better compound annual return than from the Standard & Poor’s 500 stock index, based on his- tory, but with more risk. Since 1970, the Morgan Stanley Capital International (MSCI) index of foreign developed stock markets, known as the EAFE (Europe, Australasia, Far East) index, has had a compound annual return of 11.6 percent, with a risk mea- sure of 21.9 percent.6 The return is 1.2 percentage points more than that for the S&P 500, while the risk level is 1.8 points higher.
But the biggest bang for the buck comes from emerging stock markets. Their risk is not much higher than smaller company stocks and they have had a higher return. So you always have to consider both numbers together.
These emerging stock markets are in both the world’s well- known, rapidly developing economies, including China, South Korea, India, Brazil, and Russia, and in some less well-known de- veloping economies, including Sri Lanka and Zimbabwe. This is one of the biggest risk shifts most Americans will have to make in the years ahead to increase returns.
Despite their roller-coaster history, emerging stock markets, based on the performance of the MSCI index for these markets, have a risk level that is only slightly higher than small-cap stocks—33.6 compared to 32.7. But the compound annual return for emerging stock markets through 2006 was 15.2 percent, com- pared to 12.7 percent for small-cap stocks. In a race of two
$250,000 portfolios, the emerging market one would be at $2.1 million in 15 years, when the small-cap portfolio would be at
$1.5 million.
The bond markets in emerging market countries, which are sort of equivalent to the high-yield or junk bond market in the
United States, also offer a step up in return and risk for willing American investors. Emerging market bonds have had a com- pound annual return of 10.9 percent since 1994, with a risk level of 14.8, based on JPMorgan’s Emerging Markets Bond Index (EMBI) Global.7
Because of these risk-return numbers, foreign markets present the best and most diverse place for Americans to take on more risk in their effort to improve their average returns over time.
Outside of stocks and bonds, an investor can consider com- modities as another asset class for increasing risk in a portfolio.
Since 1970, the return of the Goldman Sachs Commodity Index, which includes gold, oil, wheat, copper, and lean hogs, has had a compound annual return of 11.5 percent, while the standard de- viation has been 24.1.8This may seem a little far afield for some investors, but, as we will show in Chapter 2, commodities can also be a good diversifying additive to a portfolio that reduces overall risk. And commodities have had an amazing run the past eight years, with a compound annual return of 14.5 percent through 2006.