The randomness of_returns

Editor's Notes

• #2: Talking Points: This example features annual performance of major asset classes in the Canadian, US, and international markets between 1996 and 2011. • The top chart ranks the annual returns (from highest to lowest) using the colours that correspond to the asset classes. • The bottom chart displays annual performance by asset class. There is little predictability in asset class performance from one year to the next. Studying the annual data in the slide reveals no obvious pattern in returns that can be exploited for excess profits, strengthening the case for broad diversification across many asset classes.
• #3: Talking Points: Investors need portfolios that reflect their different financial goals, time horizons, and risk preferences. Although there is no “perfect” portfolio, many investors will find that a sensible approach incorporates diversification across multiple sources of risk and return. This slide illustrates how various portfolios along the risk/return spectrum (e.g., conservative, moderate, aggressive) might be constructed to capture the equity, size, and value risk premiums in global markets. The more aggressive strategies hold more equity, while the less aggressive strategies hold more fixed income. To simplify the illustration, the relative proportion invested in each component within the equity allocation (large cap, small cap and value) remains consistent. As total equity exposure increases in the portfolios, global diversification is maintained by allocating consistent relative proportions to risk factors in the Canadian, US, and international markets. This exhibit clarifies the proper role of equity and fixed income in a balanced portfolio. Even for the most aggressive investor, broad global diversification across multiple asset classes is desirable. Investors seeking greater safety should allocate a larger fraction to fixed income while maintaining a similar diversified equity exposure.
• #4: Talking Points: Asset class returns vary considerably from year to year, and past returns offer little insight into future performance. However, combining multiple asset classes tends to minimize the volatility associated with this random behavior. Global diversification reduces the effect of a single asset class or market. The historical returns chart offers compelling evidence that structured portfolios are a reliable way to capture the returns associated with multiple measures of risk across the global capital markets. The upper chart ranks the year-to-year returns (from highest to lowest) of the model portfolios using the corresponding colors. The lower chart features historical annual performance of the model portfolios over a fifteen-year period, with the far right columns showing annualized returns and standard deviations for the entire period. The dispersion of colors now appears more uniform and consistent, with annual returns based on risk assumed in the model portfolios. This example illustrates how markets tend to reward investors for the risks they bear, with riskier strategies generally offering higher expected returns.