A question concerning expected returns of model portfolio

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Carol88888
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Joined: Wed Jan 24, 2018 2:24 am

A question concerning expected returns of model portfolio

Post by Carol88888 » Wed May 16, 2018 6:32 pm

I saw a portfolio in a book by Swedroe ("Reducing the Risk of Black Swans" 2014) that showed a portfolio like this:
30% S&P
30% Small Cap
40% 5-year treasury notes.

It gave as the expected return 12%. I was dumbfounded. That's all I need to do to get a 12% return - oh, boy! But something didn't look right to me. I understand that no one can ever predict the exact return in any one decade but I am asking, do any of you think 12% would be doable, say over 20-30 years?

When I plug in what I consider expected returns, I use 9% for S&P; 10.5% for small cap and 4% for 5 year note and get a portfolio return of about 7.45%

9 x.3 plus 10.5 x.3 plus 4x.4.

(Even that 4% for a 5 year note is stretching, I know from today's valuation but I am trying to plug in a more normal value.) Am I doing the math wrong or am I missing something else?

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willthrill81
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Re: A question concerning expected returns of model portfolio

Post by willthrill81 » Wed May 16, 2018 6:43 pm

I think you're misreading something. While I haven't seen Larry Swedroe recommend that specific portfolio, the nominal returns for it were 9.97% from 1972 until today.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

Random Walker
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Joined: Fri Feb 23, 2007 8:21 pm

Re: A question concerning expected returns of model portfolio

Post by Random Walker » Wed May 16, 2018 10:09 pm

Carol88888,
I think you are calculating expected returns correctly: a weighted average of the expected returns of the individual portfolio components. I looked up the example you describe from Larry’s 2014 book. Those are actual returns data from1975-2013. As I’m sure you’ve read, expected returns are simply a mean with a very wide distribution. I also agree with you that it is far superior to take into account current valuations when making your expected return estimates.
Note that the expected return of a portfolio is the weighted simple mean of the portfolio components. The expected SD of a portfolio is less than the weighted mean of its components due to correlations less than 1. The compounded return of a portfolio is always less than the simple mean return of its components because of portfolio volatility. By adding components that keep expected return of the portfolio constant (simple mean) but decrease the portfolio SD, we can actually expect to bring the compounded return closer to the simple average return. This is a more efficient portfolio. The actual return we eat is the compounded one, so portfolio efficiency matters.
Larry focuses in his books on narrowing SD and minimizing downside risk because he finds that is what is most important to investors. But what I’m describing is just the other side of the more efficient portfolio coin. If interested look up “volatility drag” in the wiki or a long thread I started on the subject in the past.

Dave

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