THREAD IS CLOSED!!! Ask Rande 6000+ USE NEW THREAD

» Rande - An expected annual standard deviation of 10% with an expected av

An expected annual standard deviation of 10% with an expected average annual return of 10% means that in any given year you could experience a return of as high as 20% or as low as 0%. One standard deviation represents two-thirds of the possible outcomes, so certainly the potential for returns outside the range is still high. Two-standard deviations (98% of the possible outcomes, given expected risk and return) is typically used for long-term projection purposes. For example, a portfolio of 50% municipal bonds, 28% large-cap U.S. stocks, 10% small-cap U.S. stocks, and 12% international stocks might have the following MPT stats, depending your data inputs:

Before-tax return: 8.2%
After-tax return: 6.6% (assuming highest fed/CA rates and turnover of 40% in the bonds, 50% in the large-caps, 100% in the small-caps, and 75% in the international)
Standard deviation: 8.75%
Yield: 3.33%

Using TWO standard deviations, following is the "best case" (meaning there is only a 2% probability of outperforming this level) and "worst case" (meaning there is a 98% chance of outperforming this level) --

[Returns are all AFTER-TAX showing best case annual and worst case annual, with 6.6% being the expected average return throughout]

One year: Best 25.6%, Worst -9.5%
Four years: Best 15.7%, Worst -1.7%
Eight years: Best 13%, Worst .6%
Eleven years: Best 12%, Worst 1.5%
Fifteen years: Best 11.2%, Worst 2.2%

The range of returns for any given time period illustrates the basic investment management concept of short-term volatility with regression to the mean over longer-term periods, as well as the efficacy of holding assets that, while seemingly "risky" in the short-term, provide the best potential for capital accumulation over longer periods of time. All based on the assumptions used, of course (no sure-fire crystal ball/black box).

-- posted by Rande

Permalink Print Discussion Join the latest discussions

» Kirk - Thanks Rande

Great analysis!

What happens with 1 and 2 sigma best and worst case for:

80:20 Equities:Munis
20:80 Equities: Munis

Perhaps you should put this analysis in your homepage for posterity? I think it is very valuable!

I thought 2 sigma integrated to 97%, not 98%?

Also, I believe these returns are for a closed system. In an open system where you are working and adding dollars every paycheck with a 401K and company stock purchases... you actually get to buy the dips and improve your returns.

-- posted by Kirk

Permalink Print Discussion Join the latest discussions

» Rande - Kirk,

Kirk,

97%...98%...cosa differensa? We're not talking exact science here (as much art as science, maybe more). Don't have my statistics text handy, but I do believe that on bell curve, two sdevs represents 98% of the possible outcomes. It is VERY important to not attach TOO much reliance on the computations. Most MPT software will spit out expected returns and standard deviations to fourth decimal. Gives a false impression of accuracy in my opinion. Anyway, here's the stats as you requested:

[same assumptions about tax brackets and turnover and expectations of return/sdev of 10.5%/16% for large-caps, 12%/23% for small-caps, 11%/21% international, and 5.5%/10% muni]

80/20 -- 50% large-cap, 15% small-cap, 15% international, 20% municipal bond

Portfolio stats:

Before-tax expected return: 9.8%
After-tax expected return: 7.3%
Standard deviation: 10.9%
Yield 2%

Best case/worst case (after-tax):

One year: 31.2%, -12.3%
Five years: 17.4%, -2%
Ten years: 14.3%, .7%
Fifteen years: 13%, 1.8%
Twenty years: 12.2%, 2.5%

20/80 -- 12% large-cap, 4% small-cap, 4% international, 80% municipal bond

Portfolio stats:

Before-tax expected return: 6.6%
After-tax expected return: 6.0%
Standard deviation: 7.5%
Yield 4.6%

Best case/worst case (after-tax):

One year: 22%, -8%
Five years: 12.8%, -.5%
Ten years: 10.8%, 1.3%
Fifteen years: 9.9%, 2.2%
Twenty years: 9.3%, 2.7%

Analysis -- Focusing on the long term, two things pop out:

1. Over a twenty year period, the worst case for both portfolios is nearly identical, but the best case for the 80/20 mix is almost 3% better.

2. The average annual return for the 80/20 mix of 7.3% may not seem like much more than the 6% expected return for the 20/80 mix, but over twenty years it would result in $100,000 growing to $409,255 instead of $320,714. Not a big deal if you already have critical mass, but for young investors in the capital accumulation mode it could mean the difference between a comfortable retirement or not.

BTW -- EITHER portfolio might be considered appropriate, depending on the individual investor's time horizon, risk tolerance (benefits of long-term investing don't matter if you fail to get there because of nervousness over the short term), goals and objectives. No one size fits all.

-- posted by Rande

Permalink Print Discussion Join the latest discussions

» FCSTECKIII - Kirk and Rande

Kirk, I'm afraid your question is a bit out of
my league, however ...

Rande, thank you for explaining this in detail.

I'm still evaluating and analyzing the results
of the software ...

Its interesting to see how the optimizer builds
an efficient asset allocation portfolio based on
the amount of risk taken ...

What's interesting is that by adding small-caps
or International funds to the overall mix, one
can achieve greater returns without increasing
the risk ...

-Thanks Guys

-- posted by FCSTECKIII

Permalink Print Discussion Join the latest discussions

» Kirk - Thanks for the analysis Rande!

Thanks for the analysis Rande!
As always, first rate.

Also confirms what I had seen, but not calculated that 80:20 is ideal for 20 yrs or longer even if retired... and that compounging difference is amazing, even if ONLY 1% or so, it adds up. Reminds me of how paying taxes EARLY is so deadly to overall returns...

-- posted by Kirk

Permalink Print Discussion Join the latest discussions

» Rande - Fred,

Fred,

Good observation and gets to the heart of MPT -- by adding a combination of assets that when held in isolation ARE OTHERWISE RISKY, the portfolio's overall volatility CAN BE REDUCED. The reason? Covariance. The objective? To obtain the highest possible expected rate of return given an acceptable level of expected volatility.

-- posted by Rande

Permalink Print Discussion Join the latest discussions

» FCSTECKIII - Rande

I realize that MPT is 'old hat' for a person in
your position so thanks are in order for being
tolerate of my 'student' mentality ...

-Thanks again.

-- posted by FCSTECKIII

Permalink Print Discussion Join the latest discussions

» pjstack - Question for Rande.

At the moment my portfolio is 100% stocks & stock mutual funds. I'm able to live OK on my military pension & social security (I'm single, so it's no big trick to do so!). I've been thinking about bonds, and I read an article by Michael Sivy (Money magazine) about the relatively new government I Series bonds (Inflation adjusted). They come in denominations of $50 through $5,000 and are currently paying 7.49% (That's pretty good, isn't it?) You can buy them through banks and cash them at most any bank,too. No commissions and you can even buy them direct from the govt. on the internet. Do you have any experience with them? Any thoughts on the matter? It all seems pretty painless to me? AmI missing something?
Phil Stack.

-- posted by pjstack

Permalink Print Discussion Join the latest discussions

» JenL_2 - I-Bonds

Hi PJ - We've had quite a lot of I-Bond discussion on the "Bonds" thread. Here's one post:

Inflation Indexed Savings Bonds

.....Jen

-- posted by JenL_2

Permalink Print Discussion Join the latest discussions

» JackSwanson - Folks....

The futures are deep red again tonight. We are in deep trouble, because you know the fed is gonna raise rates six more times. I'm holding long, but I'm payin' a big price. You see, Jack has been slaughtered.

-- posted by JackSwanson

Permalink Print Discussion Join the latest discussions