Vanguard
Asset allocation: the classic risk:return tradeoff
Against the current backdrop of low US interest rates and elevated economic volatility, what are reasonable expectations for US bond and stock returns and the potential implications for strategic asset allocation? Joseph Davis, Roger Aliaga-Díaz and Andrew Patterson explain.
Three simple, but crucial, questions Given the macroeconomic backdrop, we sought to address three
simple yet fundamentally important questions for strategic asset allocation.
1. What is a reasonable range of expected returns (both nominal and real) for a balanced portfolio of stocks and bonds based on present market conditions?
2. How does this range of returns compare with both long-term historical averages and the more recent past in the US, as well as with the last decade in Japan?
3. Should this range of expected returns alter an investor’s approach to asset allocation in light of the prevailing concerns over future US growth, infl ation, and interest rates?
Simulating future portfolio returns To examine potential implications for asset allocation, we used
the Vanguard Capital Markets Model (VCMM) to generate 10,000 simulations of potential 10-year stock and bond return paths based on market conditions as of September 30, 2011, and various scenarios for future interest rates, infl ation, and other risk factors.
Figure 1 presents the results. It shows the simulated return distributions
for three hypothetical portfolios ranging from more conservative to more aggressive:
1. 20 percent equities/80 percent bonds; 2. 50 percent equities/50 percent bonds; and 3. 80 percent equities/20 percent bonds. The chart on the left shows the distributions for nominal returns;
the chart on the right displays the distributions of returns adjusted for the rate of expected consumer price index infl ation. For reference, both charts also show how the hypothetical portfolios would have performed in 1926–2010 and 2000–2010.
Three implications for strategic allocation Figure 1’s two charts have at least three key implications for strategic
asset allocation. The fi rst is that balanced portfolio returns over the next decade are likely to be moderately below long-term historical averages (indicated by the red dots). Put another way, the mean- variance frontier of expected returns may now be somewhat lower for all but the most aggressive portfolios than has been realised, on average, over the past 85 years.
Figure 1: VCMM-simulated distribution of expected annualised 10-year returns for balanced portfolios Nominal returns, 10-year horizon
Real returns, 10-year horizon
16% 14% 12% 10% 8% 6% 4% 2% 0% -2% -4%
US History 1926-2010 US History 200-2010
90th percentile
25th-75th percentile
10th percentile 20/80 50/50 Portfolio Stock/Bond Allocation 80/20
16% 14% 12% 10% 8% 6% 4% 2% 0% -2% -4%
US History 1926-2010 US History 200-2010
90th percentile
25th-75th percentile
10th percentile 20/80 50/50 Portfolio Stock/Bond Allocation
Notes: Percentile distributions are determined based on results from the VCMM. For each portfolio allocation, 10,000 simulation paths for US equities and bonds are combined, and the 10th, 90th, 25th, and 75th percentiles of return results are shown in the box and whisker diagrams. The dots indicating US historical returns for 1926–2010 and 2000–2010 represent equity and bond market annualised returns over these periods. The equity returns represent a blend of 70 percent US equities and 30 percent international equities; bond returns represent US bonds only. Returns are based on the broad- market indexes listed in the box below.
Sources: Barclays Capital, Thomson Reuters Datastream, and Vanguard calculations, including VCMM simulations, and index returns 80/20
bermuda captive 2012 35
Annualised Geometric Return
Annualised Geometric Return
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