Asset class winners and losers It is impossible to predict which asset class will be the best or worst performing in any given year. The performance of any given asset class can have drastic periodic changes. This image illustrates the annual performance of various asset classes in relation to one another. In times when one asset class dominates all others, as was the case for large stocks in the mid-to-late 1990s, it is easy to ignore the fact that historical data shows it is impossible to predict the best performing asset class for any given year. Investors betting on another stellar performance for large stocks in 1999 were certainly disappointed as small stocks rose from the worst performing asset class in 1998 to the best performing in 1999. These types of performance reversals are evident throughout this example. A well-diversified portfolio may allow investors to mitigate some of the risks associated with investing. By investing a portion of a portfolio in a number of different asset classes, portfolio volatility may be reduced. Note: Information shown is illustrative and is not indicative of any specific investment.
Stocks, Bonds, Cash, and Inflation: summary statistics 1926–2003 This image summarizes, quantitatively, the risk/return trade-off inherent in investing; that is, the potential return of an asset generally increases with the asset’s risk. The compound annual return shown in the first column reflects the annual rate of return achieved over the entire 78-year time period assuming the reinvestment of all income. It is the average rate of return which, when earned each year, equates the investment’s beginning value with its ending value. The figure in the second column represents a simple, or arithmetic average, of the individual annual returns over the past 78 years. Standard deviation, shown in the third column, is used to measure the risk of an investment. It shows the fluctuation of returns around the arithmetic annual return of the investment. The higher the standard deviation, the greater the variability of the investment returns. The “skyline” or distribution for each asset class graphically depicts the information contained in the summary statistics table. Riskier assets, such as stocks, have spread out “skylines,” reflecting the broad distribution of returns from very poor to very good. Less risky assets, such as bonds, have narrow “skylines,” indicating a tight distribution of returns around the average. Note: Information shown is illustrative and is not indicative of any specific investment.
Stocks, Bonds, Cash, and Inflation ® 1925–2003 A 78-year examination of past capital market returns provides historical insight into the performance characteristics of various asset classes. This graph illustrates the hypothetical growth of a $1 investment in four traditional asset classes, as well as inflation, over the time period December 31, 1925 through December 31, 2003. Large and small company stocks have provided the largest increase in wealth over the past 78 years. The fixed-income investments provided only a fraction of the growth provided by stocks. As illustrated in this image, stocks produced greater returns and a higher ending wealth value than that of fixed-income investments. However, these higher returns are associated with much greater volatility (risk). Furthermore, small company stocks may be subject to a higher degree of market risk than large company stocks. Note: Information shown is illustrative and is not indicative of any specific investment.
Stocks and bonds: risk versus return 1970–2003 An efficient frontier represents every possible combination of assets that maximizes return at each level of portfolio risk and minimizes risk at each level of portfolio return. An efficient frontier is the line that connects all optimal portfolios across all levels of risk. An optimal portfolio is simply the mix of assets that maximizes portfolio return at a given risk level. This image illustrates an efficient frontier for all combinations of two asset classes: stocks and bonds. Although bonds are considered less risky than stocks, the Minimum Risk Portfolio does not consist entirely of bonds. The reason is because stocks and bonds are not highly correlated; that is, they tend to move independently of each other. Sometimes stock returns may be up while bond returns are down, and vice versa. These offsetting movements help to reduce overall portfolio volatility (risk). As a result, adding just a small amount of stocks to an all-bond portfolio actually helps reduce the overall risk of the portfolio. However, including more stocks beyond this point caused both the risk and return of the portfolio to increase. Note: Information shown is illustrative and is not indicative of any specific investment.
Reduction of risk over time 1926–2003 One of the main factors you should consider when investing is the amount of risk, or volatility, you are prepared to assume. However, recognize that, on an annualized basis, returns appear less volatile with longer holding periods . Over the long term, periods of high returns tend to offset periods of low returns. With the passage of time, these offsetting periods result in the dispersion of returns gravitating or converging toward the average. In other words, while returns may fluctuate widely from year to year, holding the asset for longer periods of time results in apparent decreased volatility. This graph illustrates the range of compound annual returns for stocks, bonds, and cash over 1-, 5-, and 20-year holding periods. On an annual basis since 1926, the returns of large company stocks have ranged from a high of 54% to a low of –43%. For longer holding periods of five or 20 years, however, the picture changes. The average returns range from 29% to –12% over five-year periods, and between 18% and 3% over 20-year periods. Note: Information shown is illustrative and is not indicative of any specific investment. .
Potential to reduce risk or increase return 1970–2003 Adding stocks to a portfolio of less volatile assets can help reduce risk without sacrificing return or help increase return without assuming additional risk. This image illustrates the risk-and-return profiles of three hypothetical investment portfolios. The lower risk portfolio, which included stocks, had the same return as the portfolio comprised entirely of fixed-income investments, but assumed less risk. The higher return portfolio had the same risk level as the fixed income portfolio, but produced an increased return. Although it may appear counterintuitive, diversifying a portfolio of fixed-income investments to include stocks can help reduce the overall volatility your portfolio experiences. Likewise, it is possible to increase your overall portfolio return without having to take on additional risk. Because stocks, bonds, and cash generally do not react identically to the same economic or market stimulus, combining these assets can often produce a more appealing risk-and-return trade-off. Note: Information shown is illustrative and is not indicative of any specific investment.
Diversified portfolios and bear markets Diversification can help limit your losses during a severe market decline. The benefits of diversification are most evident during bear markets. This image illustrates the growth of stocks versus a diversified portfolio during two of the worst performance periods in recent history. The blue line illustrates the hypothetical growth of $1,000 invested in stocks during the mid-1970s recession and the 1987 market crash. The yellow line illustrates the hypothetical growth of $1,000 invested in a diversified portfolio of 35% stocks, 40% bonds, and 25% cash during these same two periods. Over the course of both time periods, the diversified portfolio lost less than the pure stock portfolio. Over longer periods of time, the more volatile single asset-class portfolio is likely to outperform the less volatile diversified portfolio. However, you should keep in mind that one of the main advantages of diversification is reducing risk, not necessarily increasing return, over the long run. Note: Information shown is illustrative and is not indicative of any specific investment.
Bond market performance 1925–2003 Although bonds have not been the leading asset class for wealth accumulation, they have provided relatively stable returns over the past 78 years. This image illustrates the hypothetical growth of a $1 investment in stocks, corporate bonds, government bonds, municipal bonds, and cash over the period December 31, 1925 through December 31, 2003. In accordance with their higher risk (due to risk of default), corporate bonds outperformed government bonds and Treasury bills. When compared to the ending wealth of stocks, however, corporate bonds fell short. Though municipal bonds underperformed other bonds and stocks, the income they generate is usually exempt from federal income taxes. Historically, bonds have not proven to be the best investment vehicle for long-term growth. However, there have been short periods of time when bonds have outperformed stocks, such as the mid-70s recession. For this reason, bonds can provide excellent diversification benefits. Note: Information shown is illustrative and is not indicative of any specific investment.
Relationship between bond prices and yields It is important for investors to understand the inverse relationship between bond prices and their respective yields. Although the bond market is less volatile than the stock market, bonds also fluctuate in terms of price. This image illustrates the inverse relationship between bond prices and bond yields, or interest rates. If interest rates fall, bond prices rise. If interest rates rise, bond prices fall. A simple example illustrates this concept. Suppose an investor purchases a 20-year $1,000 bond with a yield of 8% and interest payable annually at year-end. One year later, interest rates rise to 10%. Anybody in the market for a bond can now buy one with a yield of 10%. If the investor tried to sell the bond with an 8% yield for the original price of $1,000, nobody would buy it—the same amount of money could purchase a bond yielding 10%. In order to find a buyer, the investor would need to discount the bond price enough to compensate the buyer for the lower interest or coupon payments (10% – 8% = 2% less per year in interest payments). This would result in a capital loss. Conversely, if interest rates fall, the investor would experience a capital gain. Again, this is due to the inverse relationship between bond prices and yields. Note: Information shown is illustrative and is not indicative of any specific investment.
Stock performance during recessions 1945–2003 Since the stock market is driven by the performance of corporations, it is evident that a relationship exists between the performance of the stock market and the performance of the economy as a whole. There is no doubt that the state of the economy has a direct influence on stock market performance. This image illustrates the hypothetical growth of a $1 investment in stock at year-end 1945 through December 31, 2003. The shaded regions represent ten economic recessions in the U.S. since year-end 1945. Notice that the index line usually drops either before or in the middle of each shaded region. This indicates a clear relationship between the performance of stocks and the economy as a whole. Not every stock market downturn corresponded with an economic recession. For example, sharp stock market drops in 1962, 1966, and 1987 did not coincide with economic decline. Conversely, the U.S. economy remained stagnant for much of 1991, while the stock market posted impressive returns. Note: Information shown is illustrative and is not indicative of any specific investment.
Stocks and Real Assets 1983–2003 International stocks, real estate, commodities, and gold have traditionally served to lower the overall risk of a domestic portfolio. This image illustrates the hypothetical growth of a $1 investment in U.S. stocks, international stocks, commodities, real estate, and gold over the time period December 31, 1983 to December 31, 2003. The best performing asset class over this 20-year period was U.S. stocks, with $1 growing to approximately $11. International stocks, commodities, real estate, and gold are often overlooked in an investor’s asset allocation decision. These assets can be excellent vehicles for diversification purposes, because their returns have demonstrated low or even negative correlation with more traditional assets. In other words, when traditional assets have done poorly, these alternative assets may have done well, thereby helping to reduce the overall volatility (risk) of your portfolio. Commodities, real estate, and gold can also be an effective hedge against rising inflation rates. Note: Information shown is illustrative and is not indicative of any specific investment.
Returns before and after Inflation 1926–2003 Comparing the returns of different asset classes both before and after inflation is helpful in understanding why it is so important to consider inflation when making long-term investment decisions. This image illustrates the compound annual returns of three asset classes before and after considering the effects of inflation. Over the past 78 years, inflation has dramatically reduced the returns of stocks, bonds, and cash. The blue, yellow, and green bars represent the nominal, or unadjusted, returns of each asset class. Nominal returns do not consider inflation. It is often the rate of return that you might think of when discussing the returns on investments. The purple bars illustrate the real, or inflation-adjusted, returns of each asset class. Real returns reflect purchasing power. For example, if you invested in cash equivalents in 1926, the money you earned over the period provided you with very little purchasing power today. Notice that cash and bonds, after adjusting for inflation, barely kept pace with the rise in prices over the past 78 years. Note: Information shown is illustrative and is not indicative of any specific investment.
Dollar Cost Averaging Dollar cost averaging can be an effective method of turning market volatility into opportunity. Investing the same dollar amount each period will buy more shares of an asset when the price is low, and fewer when the price is high. As a result, the average purchase price is lower than the average market price over the same period. A major benefit of dollar cost averaging is that it brings a discipline to investing that most investors find difficult to achieve. It forces investors to make systematic, timely investments in differing market environments and prevents emotions from dictating investment decisions. Because you invest by the dollar’s worth instead of the number of shares, a market decline presents an opportunity to purchase more shares at favorable prices. The graph shows exactly how dollar cost averaging works: you buy more shares as the price per share falls, and fewer as the price increases. In this example, an investor who systematically invests $600 for four quarters in a mutual fund owns 114 shares after a total investment of $2,400. The average price per share over the four quarters was $22.50, but the average cost to the investor using dollar cost averaging was only $21.05. This amounts to a savings of $1.45 per share, or $165.30 overall. As long as you purchase shares at a regular time interval and with the same dollar amount, you can achieve the benefits of dollar cost averaging. Quarter Price/unit Units purchased Market average price* Dollar cost average price* 1 $20.00 30 $20.00 $20.00 2 $15.00 40 $17.50 $17.14 3 $25.00 24 $20.00 $19.15 4 $30.00 20 $22.50 $21.05 Total units purchased Total market price of units Total dollar cost average price of units 114 (114 x $22.50) = $2,565 (114 x $21.05) = $2,400 *Cumulative average price Note: Information shown is illustrative and is not indicative of any specific investment. Dollar cost averaging does not ensure a profit nor protect against a loss in declining markets. Dollar cost averaging involves continuous investment regardless of fluctuating prices. Investors should consider their financial ability to continue purchases through periods of low price levels.
Dangers of market timing 1983–2003 Investors who attempt to time the market run the risk of missing periods of exceptional returns. This practice may have a negative effect on a sound investment strategy. This image illustrates the risk of attempting to time the stock market over the past 20 years. A hypothetical $1 investment in stocks invested at year-end 1983 grew to $11.50 by year-end 2003. However, that same $1 investment would have only grown to $2.71 had it missed the 16 best months of stock returns. A one dollar cash investment over the 20-year period resulted in an ending wealth value of $2.79. An unsuccessful market timer, missing the 16 best months of stock returns, would have received a return that was lower than Cash. Although successful market timing may improve portfolio performance, it is very difficult to time the market consistently. In addition, unsuccessful market timing can lead to a significant opportunity loss. Note: Information shown is illustrative and is not indicative of any specific investment.
Dangers of market timing 1925–2003 Investors who attempt to time the market run the risk of missing periods of exceptional returns. This practice may have a negative effect on a sound investment strategy. This image illustrates the risk of attempting to time the stock market over the past 78 years. A hypothetical $1 investment in stocks invested at year-end 1925 grew to $2,285 by year-end 2003. However, that same $1 investment would have only grown to $17.42 had it missed the 37 best months of stock returns. One dollar invested in Cash over the 78-year period resulted in an ending wealth value of $17.66. An unsuccessful market timer, missing the 35 best months of stock returns, would have received a return that was lower than Cash. Although successful market timing may improve portfolio performance, it is very difficult to time the market consistently. In addition, unsuccessful market timing can lead to a significant opportunity loss. Note: Information shown is illustrative and is not indicative of any specific investment.