bigred77 wrote: ↑
Thu Aug 17, 2017 8:27 am
North Texas Cajun wrote: ↑
Thu Aug 17, 2017 12:53 am
I was comparing the standard deviation of the annualized returns of US equities and government T bonds over the past 200 years. As Professor Jeremy Siegel showed in his book, "Stocks for the Long Run", the standard deviation of annualized returns for equities drops from 18% for one year periods to under 2% for 30 year periods. The standard deviation for T bonds was 8+% for one year periods and 2+% for 30 year periods.
Siegel showed that for holding periods of 20 years and 30 years, U.S. Equity returns have had lower standard deviations than T bonds returns.
Because the standard deviation of returns for an all equity portfolio held for 20 or 30 years has been lower than that for bonds, and because an all equity portfolio is far more likely to have higher returns, I do not believe an all equity portfolio to be risky for a buy and hold investor with a 20 or 30 year horizon.
It is possible that a 60/40 portfolio could have a lower standard deviation of 30 year returns. I do not have the data for that. The efficient frontier line for 30 year returns in Dr. Siegel's book seems to show the standard deviations are the same, with the SD for 70/30 and 80/20 portfolios just barely lower - lower by less than 1/10 of 1 percent.
You may not accept the historical SD's of 30 year returns to be an acceptable definition of risk for a long term investor. I think that is the most appropriate measure.
We can derive historical Sharpe ratios for daily returns, monthly returns, annual returns, ten year returns, or thirty year returns. As I see it, anything based on less than 10 year rolling periods should be considered noise for the long term investor. The Sharpe ratio is probably higher for the 60/40 portfolio when using ten year rolling periods but lower for 30 year returns.
In regards to the bolded, yes I think volatility is an appropriate measure of risk but now I think I see why we aren't seeing eye to eye. I am referring to volatility of a portfolio throughout the entire 30 year period. I'm describing the ups and downs of the behavior. You are referring to volatility of a portfolio only at the end of 30 years. You are referring to volatility strictly as a measure of how close observed returns cluster around the mean of the sample at the end of a defined time frame.
Consider a 0 coupon bond that matures in 30 years (issued by the US government and I am assuming no default risk for the sake of simplicity). A STRIP that one can actually go buy today in the market if they want. You pay X for it today. No interest payments are made over 30 years. In 30 years the US government pays you exactly the par value in nominal terms. That bond has a big duration and is subject to interest rate risk. As interest rates change over the next 30 years the market value of that bond can swing up and down. That bond has volatility. It is definitely not a straight line growth chart. At the end of 30 years I get paid par value. That nominal value was never in doubt. At the maturity date, if I plot the probability distribution on a graph, there just a single vertical line that shows 100% on the nominal par value. The standard deviation of that probability distribution is 0. You are saying that bond has no volatility and is 0 risk for the long term investor. I am saying that bond does in fact carry risk and contains volatility. I think that is the disagreement we are having.
All else being equal, I generally defer to the maxims that risk and return are linked and there is no free lunch in investing except diversification. I accept 100% equity portfolios will beat 60/40 portfolios over long periods of time the vast, vast majority of the time. This is because they are riskier. There is a lot of consensus on this side of the argument. Volatility in the short term (over months, years, decades, etc.) SHOULD matter in my opinion, even to the long term investor with the 30 year horizon. You disagree and that's fine, but I think it would be a good idea in the future for you to pre-define how you are using the terms "risk" and "volatility" because you are assigning meanings to those terms that are contrary to the commonly accepted meanings.
First, I don't think I wrote anything about the volatility of nominal returns. So I disagree that I said this:
"You are saying that bond has no volatility and is 0 risk for the long term investor."
Second, I tried to be very clear that I was referring to the standard deviation of the historical population of 20 and 30 year real returns of U.S. equities and U.S. bonds. Perhaps I should review my previous comments to be sure.
With respect to whether my meanings of risk and volatility are contrary to commonly accepted meanings: although many investment journalists only refer to the volatility of annual or monthly returns, many academic researchers have compared the Standard deviations and Sharpe ratios of investments over varying holding periods. Almost every study I've seen which considers 1 year vs 5 year vs 20 and 30 year holding periods points out that equities become less volatile than bonds when the holding period is 20 years or more.
Here's a passage from Professor Jerrmy Siegel's widely read book, "Stocks for the Long Run":
"Standard deviation is the measure of risk used in portfolio theory and asset allocation models. Although the standard deviation of stock returns is higher than for bond returns over short term holding periods, once the holding period increases to between 15 and 20 years, stocks become less risky than bonds. Over 30-year periods, the standard deviation of equities falls to less than three-fourths that of bonds or bills. The standard deviation of average stock returns falls nearly twice as fast as for fixed-income assets as the holding period increases."
You may not agree that the standard deviation of rolling 20 or 30 year returns is an appropriate measure of risk. I see it this way: the standard deviation, or volatility, of assets based on weekly returns would not be appropriate for investors with a three-year horizon. Weekly variations would be noise that should be ignored. For investors who plan to buy and hold for 30 years, annual variances of asset returns are likewise noise which should be ignored.
I recognize that many investors do not have the tolerance for short term risk that I have. Where we probably disagree is that I believe such risk aversion is the result of advisors and mass media constantly pounding in their heads that stocks are risky. I suppose I should be happy that the majority of investors are so averse to very short term fluctuations, as I have been able to enjoy much higher returns than I otherwise would with my aggressive equity portfolio.