Thursday, October 31, 2013

My Favorite Investment Chart

As promised, here is a post describing my favorite investment chart.  It shows how diversification reduces volatility, the value of sticking with an asset allocation, and the folly of chasing the hottest sectors--among other things. Here's the chart, titled "BlackRock ASSET CLASS RETURNS A 20-Year Snapshot":


CLICK TO MAKE LARGER  To appreciate this chart ,you may want to go to the link above and print out the 2 pages comprising this chart for future reference and study.

The chart shows yearly returns of 7 different market sectors, including cash, international stocks, bonds, etc., color-coded each year.  The best-performing sector is shown at the top of the column, and all sectors are shown by performance in descending order.

Quiz question:  Quick:  Which was the best-performing sector in 2000?  Answer: "Fixed Income." Fixed Income is the bond sector.  What was its return?  11.6%.

Notice that Fixed Income was the best-performing sector for 3 years from 2000 thru 2002 and then fell close to the bottom in subsequent years.  Look closely at the table and you'll see this happens often with various sectors.  Sadly, investors don't understand this and chase the hottest sectors and, thereby, hurt their performance.

Several Wall Street firms put out charts similar to this one (referred to sometimes as periodic table of returns), but the reason I prefer BlackRock's is that it shows a diversified portfolio -  shown as the white box.  You'll notice that the diversified portfolio is never among the top 2 performers; but, by the same token, is never among the bottom 2 and is among the bottom 3 on only 2 occasions.  Simply, it is a visual depiction showing that diversification (the white box) reduces volatility.  Notice also when you print the chart out that the actual diversified portfolio is described in the very last footnote on page 1 - basically it is 65% stocks/35% Bonds.

The second page shows the cumulative and average numbers.  Note that the diversified portfolio returned 7.9% yearly on average, which grew $100,000 to $461,667.  You'll also notice that 

Source: BlackRock

although there were sectors that outperformed the diversified portfolio over the 20-year period, they had considerably greater volatility as indicated by the standard deviation.

A final basic point to pick out from the chart is  how Fixed Income performed when the stock market dropped.  Check especially those years when Large Cap stocks had negative performance (for example, 2008 when Large Cap was down -37%!).  This will give you a feel for the hedging property of bonds!

The chart can be used to answer a lot of questions that might occur to the curious investor.  For example, you may wonder what would have happened if you started 20 years ago with $500,000, took out 5%/year on an inflation adjusted basis (would need yearly data on the Consumer Price Index), and had a diversification of 70% stocks/30% bonds.  Using an Excel spreadsheet can answer a question like this, or your own variation, fairly easily.

Spending time with this chart will certainly pay large dividends (I apologize - I couldn't resist) ;)

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