North Star
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Though being serious, the fixed income/bond challenge is going to be very difficult for us all to navigate through at some point in the near future, and especially so for the more cautious investor who may not realise that bond investments especially long duration ones can go significantly under water, before gradually gliding back to par at effective maturity.
How to read the chart
1) Ignore everything except the first column
2) First Column has the Euro short term rate at the top. This is the return you would have earned from "cash" between 1970 and 2014. Over this period the return was 5.18%pa (source Deutsche Bundesbank) So, this is the "risk free rate" you could have had this for "free". Note that over this period inflation averaged 2.73%pa
3) What we are interested in is this. Cash isn't paying 5% today - more like zero. So, if I start with a lower interest rate, what should I expect from an investment portfolio.
4) The number shown in bold in the table is the risk premium for the portfolio above this "base" number. So top left hand corner, the number is 1.889.
That means that the conservative portfolio (80/20) averaged 1.889% above the Euro Short term rate of 5.18%pa over the period.
Note that the period include high inflation in the 70s, poor market returns, good market returns and both falling and rising interest rates.
5) The second number (T Stat) is 2.137 this is a measure of statistical significance and measure how confident we should be in the average premium (it was developed in Dublin incidentally) the test looks at the mean, the standard deviation of the mean and the number of observations. A T stat of 2 or more is generally taken to be statistically significant.
For forward planning purposes, if we assume a Euro short term rate of say 1% over the medium term then our Expected portfolio return is the Euro short term rate plus the average premium. So, putting it all together: For a nominal target of 4.25%pa we need around 45%- 50% in Equities. For a real (inflation protected) return of 6.25%pa we need around 80% in equities.
This is simply saying that the average return of a portfolio between 2000 and 2012 has been lower than the average return between 1926 and 2012. In other words investors should prepare themselves for lower returns in the future than they have received in the past. I think it is helpful to put some real evidence in to support statements that are fundamental to the debate.
I didn't say that. The issue is (repeated elsewhere on askaboutmoney) that we individually customise each portfolio to the particular needs of each client rather than shoehorning them into a limited range of static models. I therefore can't answer that question as I don't know the inputs.
I certainly agree with Jim that absolute return funds are hedge funds by another name and have no place in the portfolio of any retail investor, in my humble opinion.
However, I wouldn't necessarily agree that a real rate of return of 3% per annum, after fees and charges, is a particularly modest expectation from a balanced portfolio of stocks and bonds.
Obviously nobody knows what the future holds and forecasting returns on publicly traded securities is a fraught exercise. What we do know is that stocks are riskier (more volatile) than bonds and bonds are riskier than cash. Therefore, over the long term, the expected return on stocks is higher than the expected return on bonds and the expected return on bonds is higher than the expected return on cash - most of the time!
At current valuations, some of the more optimistic commentators are forecasting that the real (after inflation) return on large-cap developed market stocks, over a 30 year investment horizon, will be around 5% per annum and the real return on short term government bonds or cash will essentially be zero. On the basis of these forecasted returns, an allocation of 60% to large cap developed market stocks (with the balance of the portfolio in cash) would be required to achieve a real return of 3% per annum before fees and charges. If fees and charges (including portfolio trading costs) amount to 1% per annum, the required allocation to developed market large cap stocks jumps to 75% to achieve the desired 3% real rate of return.
A portfolio with a 75% allocation to equities would obviously be volatile - the pattern of returns from one year to the next is likely to be as smooth as sandpaper. A reasonable compromise might be to hold 50% of the ARF in a global equity fund and 50% in an intermediate term euro government bond fund and to simply accept whatever returns the market provides.
Ultimately, every investor has to balance his need or desire for return with his tolerance for the risk required to achieve that return. This is very much an individual decision that must be made with regard for an investor's overall financial circumstances. Investing is all about trading off risk and reward - there is no way around this simple fact.
Cremeegg,
1)Because it is consistent with the Barclays Equity Study from around 1900
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