Search
  • shauchi

Risk vs. Return

If you have talked with a professional money manager, you were almost certainly introduced to the 60/40 portfolio. This is an investment portfolio that has 60% of its money in stocks (usually an S&P 500 index) and 40% of its money in bonds (usually a bond index representing a full mix of the different bond types).


If we use the 10-Year Treasury Bond as a stand in for the bond index, we can easily find the data to compare a 60/40 portfolio vs. an all S&P 500 portfolio. Between 1928 and 2016, the 60/40 portfolio had 19 down years instead of 24 (a 20.8% reduction). In addition, the amount of loss during down years was also less. For example, in 1974, the 60/40 portfolio lost -14.7% while the S&P 500 lost -25.9%. In 2008, the 60/40 portfolio lost -13.9% while the S&P 500 lost -36.6%.


Clearly, the 60/40 portfolio has less risk than a pure stock portfolio. Why is this? Well, it turns out that the return on bonds has a very low correlation to the returns on stocks. Correlation is a mathematical measure of how close 2 things are to performing identically. A correlation of 1 means that the 2 things behave exactly the same, a correlation of 0 means that the 2 things behave randomly with respect to each other, and a correlation of -1 means that the 2 things behave in exactly the opposite way. Between 1928 and 2017, the correlation between stocks and bonds was 0.03.


Unfortunately, there is no free lunch. A skeptic would be thinking “So, what am I giving up in order to get this lower risk?” Well, the answer is that you are giving up the gains. While the 60/40 portfolio had more up years than the S&P 500 portfolio, those ups were smaller. The overall average per year gain of the 60/40 portfolio has been 2.5% lower than that of the S&P 500.


The reduced risk and reduced gain of the 60/40 portfolio compared to the S&P 500 is an example of the financial truism: to get greater return, you have to accept greater risk. As an example, the 10-year US Treasury bond has much lower risk than the S&P 500. However, the average rate of return for the 10-year Treasury Bond from 1928 through 2015 was 5.21%. The 3-month Treasury bill has an even lower risk, but its average return from 1928 through 2015 was only 3.57%.


So, what does this mean for a FIRE investor who has to make his money last for 40 years? If you could handle the ups and downs of the S&P 500, you would need to save $1,250,000 to support a withdrawal rate of $50,000 per year (the 4% rule) for 40 years. If you wanted the certainty of the 3-month Treasury bill, your rate of return would essentially match inflation. This means that you would need to save your annual withdrawal rate x the number of withdrawal years. Or, it means that you would need to save $2,000,000 to support a withdrawal rate of $50,000 per year for 40 years.

0 views0 comments

Recent Posts

See All

The Ugly Truth Behind the RE in FIRE

What does it mean to retire early? Social Security defines full retirement age as 67, but it allows one to claim benefits as early as 62. The IRS allows one to start withdrawing from retirement acco

FIRE and Retirement Plans

The majority of workers today do not have a pension plan. Instead, we have either a retirement plan sponsored by our workplace (401k or 403b) or a plan on our own (IRA, Keogh, Roth IRA). In general,

Options Are Not a Panacea

Under the current market conditions, I could see a FIRE saver being able to earn an additional 20% - 25% over and above their normal salary from dividends and stock and options trading. Unfortunately

SIGN UP AND STAY UPDATED!
  • Grey Google+ Icon
  • Grey Twitter Icon
  • Grey LinkedIn Icon
  • Grey Facebook Icon

© 2019 by shau_chi

  • Google+ Social Icon
  • Twitter Social Icon
  • LinkedIn Social Icon
  • Facebook Social Icon