Zaks Investment Advisory Service

Relative Performances of Various Financial Instruments

Last time, we talked about stocks and bonds. You are probable interested in what kinds of returns these various classes of securities bring. Before we discuss that, however, I need to make a few points. None of us know what the future performances of stocks and bonds will be: neither as a class of securities, and especially not as individual financial instruments. The performance of stocks is much less predictable than that of bonds (the deviation, variability of potential returns is much higher). Short-term bills are the most predictable securities. Despite the fact that many experts spend time analyzing stocks, and even make predictions about their future performance, they always do so with a disclaimer: this is our opinion and nothing more, and we are unable to guarantee you a thing. And they are not making that disclaimer just for caution’s sake: they really do not know! We will talk separately about stock performances, about the random movement of market prices, and about the impossibility of making predictions. But at the moment, what interests us is historical results. These, of course, provide no guarantee of similar future performance, nonetheless they do represent a certain indicator. And they are useful in making our future expectations of the securities market more rational. During the Internet stock company boom, many inexperienced investors decided that their incredible growth in price was the norm – and not the exception. They were deeply disappointed just a few years later.

The Chicago-based company Roger Ibbotson & Associates analyzes the historical returns on various asset classes. So, we will refer to their work. But for starters, let us once and for all define what a “return” is. If we have shares that cost $100 a year ago, and today their price is $120, then you earned an annual return of 20 percent. This is very simple. If you earned 20 percent for two years in a row, then in the end you will have $144 and not $140 – the so-called “compounding” kicks in: 20 percent of $120 is $24, so in total you would have $144. Compounding is a wonderful thing that helps a great deal if we invest over the long term. Suppose that you invested $1,000 at 12 percent a year. Without compounding, after 10 years you would have $2,200 ($120 in interest earnings a year over 10 years gives you $1,200, plus your initial $1,000 – for a total of $2,200). But if you reinvest the earned interest back at the same 12 percent, i.e. you start “compounding” your interest by, for example, using the dividend payment to buy additional shares, then thanks to this compounding after 10 years, you would have $3,106 – almost one-and-a-half times as much.

We will discuss compounding in greater detail in the future, but for now let us get back to Ibbotson’s study. Ibbotson divided all investments according to several classes: large-company shares, small-company shares, long-term corporate bonds, long-term Treasury bonds, and Treasury bills. For comparison, he added data about inflation. All this data was collated from 1926 on. For every class, he presented two figures, the average annual return and the standard deviation of the return. Here is what he came up with for the period between 1926 and 2002.

Class	Average Annual	Standard Return Deviation
Large-company shares	12.2%	20.5%
Small-company shares	16.9%	33.2%
Long-term corporate bonds	6.2%	8.7%
Long-term Treasury bonds	5.8%	9.4%
Treasury bills	3.8%	3.2%
Inflation	3.1%	4.4%

As you can see, over 76 years (from 1926 to 2002), the largest average return was earned by small companies. But at the same time, they also turned out being the most risky: I mentioned that Ibbotson also calculated the standard deviation of the annual returns. It turned out that the standard deviation on small-company shares was the highest. In other words, over some stretches of time they grew quickly, while over others, more slowly, or simply fell, thus ending up being the most risky. We will talk about risk in detail in our next program, but for now we are interested in the fact that small companies, on average, earned a return of 16.9 percent (without accounting for inflation). Large companies earned 12.2 percent, while bonds and bills – far less. In addition, Treasury bills only earned 3.8 percent, while the average inflation rate was 3.1 percent – in other words, they earned almost nothing. You may remember that we earlier said that Treasury bills are the paragon of security. We see that the safer an investment class, the smaller its return, and vice versa, the riskier it is, the more it earns. Is this a coincidence? Of course not, there is a very fundamental link between risk and return. On our site, in the Articles section, you may find the returns and growth charts of various classes of stocks and bonds. These types of things are easier to grasp visually. There, you may also compare how one dollar grows when invested in various classes of securities.

And with this, we will have to draw today’s program to a close. This was Sergey Zaks. Thank you for your attention and until next time.