Lessons for Building a Winning Portfolio_4

110 The Four Pillars of Investing Step One: Risky Assets, Riskless Assets Distilled to its essence, there are only two kinds of financial assets: those with high returns and high risks, and those with low returns and low risks. The behavior of your portfolio is determined mainly by your mix of the two. As we learned in Chapter 1, all stocks are risky assets, as are long-term bonds. The only truly riskless assets are short-term, high-quality debt instruments: Treasury bills and notes, high-grade short-term corporate bonds, certificates of deposit (CDs), and short-term municipal paper. To be considered riskless, their maturity should be less than five years, so that their value is not unduly affected by inflation and interest rates. Some have recently argued that Treasury Inflation Protected Securities (TIPS) should also be considered riskless, in spite of their long maturities, because they are not negatively affect-ed by inflation. What we’ll be doing for the rest of this chapter is setting up a “lab-oratory” in which we create portfolios composed of various kinds of assets in order to see what happens to them as the market fluctuates. How we compute the behavior of these portfolios is beyond the scope of this book; for those few of you who are interested, I suggest that you read the first five chapters of my earlier book, The Intelligent Asset Allocator. Suffice it to say that it is possible to simulate with great accu-racy the historical behavior of portfolios consisting of many assets. Keep in mind that this is not the same as predicting the future behav-ior of any asset mix. As we discussed in the first chapter, historical returns are a good predictor of future risk, but not necessarily of future return. Let’s start with the simplest portfolios: mixtures of stocks and T-bills. I’ve plotted the returns of Treasury bills, U.S. stocks, as well as 25/75, 50/50, and 75/25 mixes of the two, in Figures 4-1 through 4-5. In order to give an accurate idea of the risks of each portfolio, I’ve shown them on the same scale. As you can see, when we increase the ratio of stocks, the amount lost in the worst years increases. This is the face of risk. In Table 4-1, I’ve tabulated the return, as well as the damage, in the 1973–74 bear markets for a wide range of bill/stock combinations. Finally, in Figure 4-6, I’ve plotted the long-term returns of each of these portfolios ver-sus their performance in 1973–1974. Figure 4-6 provides the conceptual heart of this chapter, and it’s worth dwelling on for a few minutes. What you are looking at is a map of portfolio return versus risk. The numbers along the left-hand edge of the vertical axis represent the annualized portfolio returns. The higher up on the page a portfolio lies, the higher its return. The num- The Perfect Portfolio 111 Figure 4-1. All Treasury bill annual return, 1901–2000. (Source: Jeremy Siegel.) Figure 4-2. Mix of 25% stock/75% Treasury bill annual returns, 1901–2000. (Source: Jeremy Siegel.) 112 The Four Pillars of Investing Figure 4-3. Mix of 50% stock/50% Treasury bill annual returns, 1901–2000. (Source: Jeremy Siegel.) Figure 4-4. Mix of 75% Stock/25% Treasury bill annual returns, 1901–2000. (Source: Jeremy Siegel.) The Perfect Portfolio 113 Figure 4-5. All-stock annual returns, 1901–2000. (Source: Jeremy Siegel.) bers on the horizontal axis, at the bottom of the graph, represent risk. The further off to the left a portfolio lies, the more money it lost in 1973–74, and the riskier it is likely to be in the future. It’s important to clear up a bit of confusing terminology first. Until this point in the book, we’ve used two designations for fixed-income securities: bonds and bills, referring to long- and short-duration obli-gations, respectively. Bonds and bills are also different in one other respect: bonds most often yield regular interest, whereas bills do not— they are simply bought at a discount and redeemed at face value. The most common kinds of bills in everyday use are Treasury bills and commercial paper, the latter issued by corporations. Long-duration bonds are generally a sucker’s bet—they are quite volatile, extremely vulnerable to the ravages of inflation, and have low long-term returns. For this reason, they tend to be bad actors in a port-folio. Most experts recommend keeping your bond maturities short— certainly less than ten years, and preferably less than five. From now on, when we talk about “stocks and bonds,” what we mean by the lat-ter is any debt security with a maturity of less than five to ten years— T-bills and notes, money market funds, CDs, and short-term corporate, government agency, and municipal bonds. For the purposes of this book, when we use the term “bonds” we are intentionally excluding 114 The Four Pillars of Investing Table 4-1. 1901–2000, 100-Year Annualized Return versus 1973–1974 Bear Market Return Stock/Bill Composition 100%/0% 95%/5% 90%/10% 85%/15% 80%/20% 75%/25% 70%/30% 65%/35% 60%/40% 55%/45% 50%/50% 45%/55% 40%/60% 35%/65% 30%/70% 25%/75% 20%/80% 15%/85% 10%/90% 5%/95% 0%/100% Annualized Return 1901–2000 9.89% 9.68% 9.46% 9.23% 8.99% 8.74% 8.48% 8.21% 7.93% 7.64% 7.35% 7.04% 6.72% 6.40% 6.06% 5.72% 5.36% 5.00% 4.63% 4.25% 3.86% Total Return 1973–1974 41.38% 38.98% 36.52% 34.03% 31.48% 28.89% 26.25% 23.57% 20.84% 18.07% 15.25% 12.38% 9.47% 6.51% 3.51% 0.46% 2.64% 5.78% 8.97% 12.21% 15.49% long-term treasuries and corporate bonds, as these do not have an acceptable return/risk profile. I’ll admit that this is a bit confusing. A more accurate designation would be “stocks and relatively short-term fixed-income instruments,” but this wording is unwieldy. The data in Table 4-1 and the plot in Figure 4-6 vividly portray the tradeoff between risk and return. The key point is this: the choice between stocks and bonds is not an either/or problem. Instead, the vital first step in portfolio strategy is to assess your risk tolerance. This will, in turn, determine your overall balance between risky and risk-less assets—that is, between stocks and short-term bonds and bills. Many investors start at the opposite end of the problem—by deciding upon the amount of return they require to meet their retirement, educa-tional, life style, or housing goals. This is a mistake. If your portfolio risk exceeds your tolerance for loss, there is a high likelihood that you will abandon your plan when the going gets rough. That is not to say that your return requirements are immaterial. For example, if you have saved a large amount for retirement and do not plan to leave a large estate for ... - tailieumienphi.vn