Relative Performance and Risk of Various Financial Instruments

When we invest money, we obviously want to know what our return on investment will be, and how risky it is. These are natural and, one would think, simple questions. After all, anyone could go to the bank and buy a certificate of deposit (CD) for, say, one year, and earn a return of about five percent. Plus, the bank guarantees you the money. But when matters come to stocks and bonds, things are never quite so simple. Nevertheless, we will still try to make sense of them.

Last time we started talking about the average returns on stocks and bonds. We learned that according to Ibbotson & Associates research, historically, shares of small companies earned the highest average returns (16.9 percent between 1926 and 2002). Shares of large corporations earned slightly less – 12.2 percent, long-term bonds – six percent, and Treasury bills, less still – four percent. All of these results were calculated without taking account of inflation. In order to account for inflation, you would have to subtract about 3.1 percent from each result. You could also look at these numbers from another perspective: $1,000, if they gained 16.9 percent every year (i.e. at the average rate of return for small-company shares), would turn into $4,765 after 10 years. And if that $1,000 grew at the pace of large-company shares, it would turn into $3,160. Of course, you would have less money after inflation, and in real life, the actual results could be better or worse.

Source: ^©Stocks, Bonds, Bills, and Inflation 2003 Yearbook, Ibbotson Associates, Inc, Chicago

I would remind you that besides the average annual return, Ibbotson also calculated the return’s standard deviation. What is it, and why did Ibbotson decide that these figures were important enough to report to you? The average annual return – that is self-evident. But why did they also add the standard deviation? The standard deviation is a measure of the variability of a return. Suppose that certain stock’s returns were 20 percent in the first year, but that the subsequent year they fell by 15 percent. Some other stock grew by 10 percent the first, and fell by five percent the second. The variability of the return on first stock will be higher than on the second; and statistically, the standard deviation of the return of the first stock is higher than that of the second. Ibbotson analyzed annual returns on thousands of stocks during long periods. It turned out that historically, the standard deviation of return on small-company shares is the highest (33 percent), that on large-company shares slightly smaller (20 percent), and that on bonds – less still (nine percent). The lowest standard deviation is on Treasure bills, about three percent. In other words, Ibbotson’s results show that the variability (and therefore, the standard deviation) of return on small-company shares is larger than the variability of return on shares of large corporations.

A non-scientific but real-life confirmation of this happened just a short while ago: in 2000, NASDAQ, which mostly trades shares of smaller companies, at one point gained 30 percent, but fell by 36 percent by the end of the year compared to where it started. In 2001, NASDAQ fell by another 20 percent. Dow Jones, an index made up of the largest companies, which did not grow as astronomically fast as NASDAQ did in the 1990s, only lost six percent in 2000 and seven percent in 2001. By the way, standard deviation gives us a good approximation of what we may expect from various classes of securities, because about 95 percent of the results fall within the average deviation rate, plus/minus two standard deviation points.

Let us take a look at these figures one more time: over the past 76 years (between 1926 and 2002), the largest average return was earned by shares of small companies. But at the same time, they also turned out being the most risky: their annual standard deviation was the highest. Why do I say “the most risky?” Image that for some reason, you have to sell your shares. If the deviation of return is high, then there is a fairly large chance that at the moment you need to sell your shares (and earn as much money as you can), they had just suffered a fall. The high average growth rate indicates that your capital will probably be restored over time, but you do not need more money “over time,” but at a very particular point in time – right now. This is an example of risk, and we will talk about it more in the future. But for now, we see that large-company shares also earn fairly high returns (although not as high as those for smaller companies), and that the deviation of this return is lower than for small companies. Corporate and Treasury bonds, on average, earn smaller returns than stocks, but their deviations are much smaller, too. Meanwhile, Treasury bills earn a return that only slightly outpaces the rate of inflation (3.8 versus 3.1 percent), and its deviation is minimal.

We have learned one very interesting thing: the higher the risk of a certain class of securities, the higher its returns. This is what we see from historical data. Is this a coincidence? Of course not – there is a very fundamental link between risk and return. And we will have many more occasions to come back to this phenomenon.

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.

©2007 Zaks Investment Advisory Service, LLC. All rights reserved.