In the measured period, a 80/20 portfolio lost up to -1.31% to variance drain, while a 40/60 lost much less (up to -0.26%). Why isn't this variance drain discussed more often?
The following tables give return data for three-fund portfolios assuming investment in Vanguard investor share index funds. Keep in mind that past returns are no guarantee of future returns, but the history reveals how each portfolio allocation has performed over both the 2000 -2002 and 2008 bear markets and ensuing recoveries.
The tables below give 3-year, 5-year, 10-year, 15-year, and 17-year compound returns and volatility statistics for each three-fund portfolio allocation.
Added on May 20, 2018:Variance drain
A higher variance of returns results in a fund having a compound return lower than its average arithmetic return. Variance drain (compound return minus arithmetic return) measures the amount of return lost due to variance. The table below gives results over the 1997 to 2013 period.
The answer to my question is that variance drain is irrelevant because we shouldn't consider arithmetic returns in the first place.
Here's a summary I wrote later in this topic:
longinvest wrote: ↑Sun May 20, 2018 2:04 pmAs the original poster of this topic, let me try to summarize what I've learned, so far:
- One should never think in terms of average arithmetic returns. One should think in terms of compound returns (CAGR) instead when looking at past returns.
- Future returns are unknown.
- The total bond market is less volatile than the total stock market because it contains a significant amount of short-term bonds (giving it an overall intermediate duration) and, therefore, can't fluctuate as much in value as stocks, thanks to mathematics.
- International stocks are riskier than domestic ones (higher political risk, harder to enforce legal rights, currency conversion costs and spreads, etc).
- The Three-Fund Portfolio promoted by author and Bogleheads forum co-founder Taylor Larimore is an excellent approach to diversify one's exposure to various investment risks and dampen stock volatility with bonds at rock bottom cost.
- Seeking higher returns by trying to bet on future asset correlations, as promoted by author Larry Swedroe (who has an awful track record), is a form of speculation, mostly driven by greed (e.g. the hope to beat the returns of a simple three-fund portfolio using a portfolio of high-cost actively managed funds of similar volatility). (See viewtopic.php?p=3936798#p3936832 for supporting facts).