dbr wrote:But, Robert, what was your targeted result? The OP suggested at least the expected mean and expected SD, the usefulness of SD being a point for discussion. The point is that all results are only one instance from a possible distribution and we plan portfolios based on the expected distribution. The whole point of the question, it seems to me, is to specify in numbers what the rationale is for any person's adoption of a tilted portfolio and what that portfolio actually is. Actually would be what investments, and also what the factor loadings of those investments have been over the time concerned.

Long-term expectations (from start of 2003)

Annualized return = 7.5%

Standard deviation = 14

Loss in any one calendar year = 30-35%

Portfolio was constructed to align expected annualized return with needed return, and downside risk with tolerable loss.

When setting up my portfolio at start of 2003, I titled it to value and small caps, and to international to achieve my needed return. At the time, Bernstein’s expected returns for US stocks in his book Four Pillars of Investing = 6.5% (assuming a 3% inflation rate), so this was below my needed return. With a small cap and value tilt, together with foreign developed and emerging market stocks, and 25% bonds, I was able to align my portfolio expectations to both needed return and tolerable loss.

From the SD above, I should expect (or at least not be surprised by) negative returns every 6 years (1 SD), or at least a 20% loss every 44 years (2 SD). This assumes returns are normally distributed, but annual return distributions seem to have fatter tails so would not be surprised with more frequent losses.

The standard deviation also tells us more than just what to expect annually, it provides an indication of what to expect over longer time horizons e.g. 25 years. For example a SD of 14 implies returns of one in every six 25 year periods of 2.8 percent below the mean [14/SQRT(25)] i.e. there is about 16 percent odds that my portfolio return over a 25 year period may in fact be 4.7% (7.5 – 2.8). Compounded over time this is a huge difference. For each dollar invested at inception, the portfolio with a 4.7% return would accumulate into about half the value of a portfolio with a 7.5% return. This difference is reduced with additional annual savings over 25 years, but nevertheless a large difference. So I should not be surprised with this result if it materializes as this is what the standard deviation it telling me (just to note, while I mixed average and annualized returns, it still provides indicative outcomes).

FWIW I track actual progress relative to expected progress and the potential outcomes with a 16 percent odds of occurrence (implied by a standard deviation of 14). An example is provided in the chart in this earlier thread

viewtopic.php?f=10&t=7353
This, to me, illustrates the importance of also paying attention to SD to try to reduce the potential dispersion of portfolio outcomes (i.e. increase the odds of success) over an investment lifetime.

Obviously no guarantees, so also good to ensure other contingencies (e.g. perhaps when establishing needed return, initially plan on somewhat conservative estimates for savings, reasonable spending, and early retirement to allow scope to save more, spend less, work longer).

Robert

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