Real Investment Research
Our overall approach is based on four basic principles:
- Return is a product of risk.
- Time horizon, not age, determines the appropriate investment vehicle.
- Proper asset allocation is vital.
- Quality active managers can outperform indexes with less volatility.
Return is a product of risk.
To measure return, we examine the performance provided by equities (as measured by the S & P 500 Index), bonds (as measured by Ibbotson’s Corporate Bond Index) and cash (as measured by the rolling one-month CD rate) since 1970.
To measure an investment’s volatility, or risk, we use standard deviation. Standard deviation is a measure of how much the annual rate of return on an investment is deviating from the expected range of future returns.
By examining the historical results of these two investment measurements, we can make two basic conclusions. First, stocks typically provide better returns than fixed income investments, and fixed income instruments typically outperform cash. Second, stocks are more volatile than bonds, and bonds are more volatile than cash.
From 1970 to 2005, U.S. equities (as represented by the S & P 500 Index) provided the best annual return in 18 of those 35 years; corporate bonds led for nine of those 35 years; cash and equivalents led for eight years. During the same 35 years, the compound annual average return of stocks was 11.1%, bonds averaged 8.7% and cash and equivalents averaged 6.4%.
In turn, the standard deviation of stocks was 17.1, the standard deviation of bonds was 10.8 and the standard deviation of cash was 3.3, supporting our conclusions about risk.
Time horizon, not age, determines the appropriate investment vehicle.
A consideration of investment duration (the amount of time an investment is held) leads investors to favor stocks even more. In the 32 five-year rolling periods since 1970 (i.e., from 1970-1974, 1971-1975, etc.) the three investment categories had the following statistics:
|
Number of Periods with Best Annual Return |
Mean Return per 5 Year Period |
Standard Deviation |
| Stocks |
20 |
11.1% |
8.1 |
| Bonds |
7 |
8.7% |
4.5 |
| Cash |
5 |
6.4% |
2.6 |
Compared to the one-year investment horizon, the standard deviation of stocks is reduced by 50%, while return stays constant.
Proper asset allocation is vital.
We have used the S & P 500 Index to represent the return provided by stocks. However, the S & P 500 represents only a small segment of all publicly traded companies. This index largely disregards small U.S. stocks and international-based companies, and it has a strong bias toward stock growths.
By introducing another investment tool, diversification, we can further reduce risk. Specifically, consider the following allocation which uses numerous market capitalizations, geographic regions and investment styles:
MSCI Eafe Index
(International Stocks) |
22.5% |
| Large Cap Value |
20.0% |
| Ibbotson’s Corporate Long-Term |
17.5% |
| International Small-Cap Value |
12.5% |
| Large-Cap Growth |
12.5% |
| Small-Cap Value |
10.0% |
| Small-Cap Value |
5.0% |
If we replace the S & P 500 Index with the above allocation, the numbers again further favor stocks:
|
Periods as Leader |
Mean Return Per Period |
Standard Deviation |
| Allocated Portfolio |
22 |
12.6% |
6.5 |
| Bonds |
8 |
8.7% |
4.5 |
| Cash |
2 |
6.4% |
2.6 |
Quality active managers can outperform indexes.
We have identified managers across the various asset allocation categories that share our risk-sensitivity. As a result, they have consistently outperformed their respective indexes over long periods, and have done so with lower volatility.