Unpredictable Returns

We classify the investment universe into nine broadly-defined asset classes. They are listed along with the abbreviation used in the accompanying Asset Class Rankings table below:
 

Asset Class      Table Abbreviation

1. Cash TBills
2. Fixed Income Bonds
3. US Large Cap stocks US Lg
4. US Mid & Small Cap stocks US Sm
5. Real Estate Investment Trusts REITs
6. International Large Cap stocks Intl Lg
7. International Small Cap stocks Intl Sm
8. Emerging Markets EM
9. Other N/A

From period to period, asset class returns are unpredictable. Basing portfolio decisions on short-term or even intermediate-term forecasting is bound to result in frequent disappointment. Instead, the institutional asset class rebalancing approach provides a means to react unemotionally to capital market returns rather than predict them.

The illustration below is often called a “skittles chart” for its multi-colored display. It shows the annual returns of our base asset classes, represented by index data, over 15 years and ranks the returns each year from highest to lowest. We’ve also included a diversified portfolio of these asset classes that is rebalanced semi-annually. The allocations to each asset class are shown below the chart.

Two things become apparent when looking at the chart.  First, if you focus on one color at a time from left to right you see that the colors appear randomly year-to-year in the top, bottom, and center of the chart. Second, the diversified portfolio of asset classes is down the middle of the chart and never appears at one extreme or the other.  Risk reduction occurs by owning securities in all these asset classes.  The key is using the proportion that makes sense for you rather than owning one asset class or just a few.

Ultimately, combining asset classes in proportions based on individual client return and risk objectives and constraints results in portfolio returns that are more efficient than most equity asset classes by themselves:

Returns & Risk
1977-2011

Ann
Returns

Standard
Deviation
(Risk)*
Sharpe
Ratio**
       
Tbills
2.8%
2.1%
-
Bonds
5.8%
2.9%
1.03
US Lg
5.7%
20.4%
0.14
US Sm
6.2%
20.6%
0.17
REITs
9.2%
22.7%
0.28
Intl Lg
3.4%
23.1%
0.02
Intl Sm
6.0%
28.1%
0.11
EM
7.1%
38.5%
0.11
Portfolio
6.6%
15.5%
0.24
       
*Higher standard deviation indicates higher volatility of returns.
** The Sharpe Ratio measure return and risk efficiency. A higher number indicates better risk adjusted performance.

 



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