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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.

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