Each quarter Dr. David Kelly and his staff at JP Morgan Asset Management publish their Guide to the Markets. This is a comprehensive chart book of investment and economic data that I find invaluable.
For the past several quarters the Guide has included this chart which as a long-term investor should be quite important to you.
The chart depicts the range of average annual returns for stocks, bonds, and a combination of the two over rolling 1, 5, 10, and 20 year periods from 1950 through 2013. In my opinion every investor should understand the impact of diversification and time on their investments as depicted on the chart.
Understanding the chart
The green bar depicts stocks, the light blue bar depicts bonds, and the grey bar depicts a 50-50 mix of the two.
As you can see the greatest volatility of return occurs over rolling 12 month periods. The range of a 51% gain to a 37% loss in a 12 month period is huge. The range for bonds is more compact and the range for a 50-50 mx of stock and bonds is slightly more compact.
As you move out to the 5, 10, and 20 year ranges you will note that the ranges from the largest gains to smallest (or a loss) become smaller with the passage of time.
Also of note is that in no 5, 10, or 20 year rolling time frame depicted does a 50-50 mix of stocks and bonds result in a negative return over the holding period.
What does this mean to you as an investor?
Diversification dampens the variability of your returns. As you can see from the chart stocks have a wider range of returns over all of the periods depicted than do bonds. Combining the two tends to dampen the volatility of your portfolio. Further enhancing the benefits of diversification is the fact that stocks and bonds are not highly correlated.
Taking this a step further, while an investment in an index mutual fund like the Vanguard 500 Index (VFINX) would have lost money if held over that 10 year period 2000-2009, a portfolio that was diversified to include fixed income, small and mid-cap funds, international equities, and other asset classes would have recorded gains during that same time period.
Time reduces the volatility of returns. I will leave any scientific explanation to those more attuned to this than myself, but certainly part of the reason are the ebbs and flows of market and business cycle factors that have an impact on stocks and bonds. These might be recessions, interest rate movements, or other factors.
Implications for the future
The performance and characteristics of stocks and bonds might well differ in the future. Diversification for most investors will likely mean holding more than just Large Cap domestic stocks and Intermediate Bonds as the graph depicts. A few thoughts for the future, especially in this market environment of record highs for many stock market indexes:
- Diversification reduces risk.
- Diversification among assets with low correlations to one another further reduces risk.
- Diversification is important because we have no way of knowing which investments or asset classes will perform well or poorly or when.
- A longer holding period will generally serve you well as an investor in terms of smoothing out portfolio volatility.
While every investor is different as is every investment environment, diversification and patience can be two of your greatest allies.