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Risk & Volatility

The document discusses various types of risks associated with investments including market risk, inflation risk, credit risk, liquidity risk, and market timing risk. It provides data on risk and return for different asset classes such as stocks and bonds over time periods from 1926 to 2009. Diversification across asset classes can help reduce overall risk.

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Stock Diversification Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010 1 2 4 6 8 16 30 50 100 1000 Risk • Company risk • Market risk Number of stocks in portfolio

Risk Tolerance Spectrum © 2010 Morningstar. All Rights Reserved. 3/1/2010 High risk Low risk Small stocks International stocks Large stocks Corporate bonds Government bonds Cash equivalents High return Low return

Asset Class Returns Highs and lows: 1926–2009 Past performance is no guarantee of future results. Each bar shows the range of annual total returns for each asset class over the period 1926–2009. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010 Compound annual return: 11.9% 9.8% 5.4% 5.3% 3.7% Small stocks Large stocks Long-term government bonds Intermediate-term government bonds Treasury bills 150% 100 50 0 – 50 – 100 142.9% – 58.0% – 43.3% – 14.9% – 5.1% 0.0% 14.7% 29.1% 40.4% 54.0%

Reduction of Risk Over Time 1926–2009 Past performance is no guarantee of future results. Each bar shows the range of compound annual returns for each asset class over the period 1926–2009. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010 Small stocks Large stocks Government bonds Treasury bills – 60 – 30 0 30 60 90 120 150% 1-year Holding period 5-year 20-year 1-year 5-year 20-year 1-year 5-year 20-year 1-year 5-year 20-year Compound annual return: 11.9% 9.8% 5.4% 3.7%

Risk Versus Return Stocks, bonds, and bills 1926–2009 Past performance is no guarantee of future results. Risk and return are measured by standard deviation and compound annual return, respectively. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010 14% Return 12 10 8 6 4 2 0 0% Risk 5 10 15 20 25 30 35 Small stocks Large stocks Treasury bills Long-term government bonds Intermediate-term government bonds

Ibbotson ® SBBI ® Summary statistics 1926–2009 Past performance is no guarantee of future results. *The 1933 small company stock total return was 142.9%. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010 Compound annual return Arithmetic annual return Risk (standard deviation) Large stocks Small stocks* Government bonds Treasury bills Inflation 9.8% 11.9% 5.4% 3.7% 3.0% 11.8% 16.6% 5.8% 3.7% 3.1% 20.5% 32.8% 9.6% 3.1% 4.2% – 90 0 90

Stock and Bond Volatility Varies 1926–2009 Past performance is no guarantee of future results. Monthly returns in percent from 1926–2009. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010 Stocks Bonds 50% 40 30 20 10 0 – 10 – 30 – 20 1926 1946 1966 1986 2006 1926 1946 1966 1986 2006

Risk Changes Over Time Five-year rolling periods 1926–2009 Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010 0 80 70 60 50 40 30 20 10 90% Standard deviation • Small stocks • Large stocks • Long-term government bonds • Treasury bills Dec 1930 Jan 1926 1940 1936 1950 1946 1960 1956 1970 1966 1980 1976 1990 1986 2000 1996

Inflation Risk: Stocks Versus Fixed Income Range of average inflation-adjusted returns over 20-year periods 1926–2009 Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010 17.2% 4.0% 13.3% 0.8% 8.6% – 3.1% – 3.0% 2.9% Treasury bills Government bonds Large stocks Small stocks 20% Return 15 10 5 – 5 0

Treasury Inflation-Protected Securities (TIPS) A hedge against inflation,1990–2009 2.7% Annual returns $5 1 30% – 15 Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010 1990 1994 1998 2002 2006 0 Growth of $1 15 $3.65 $3.58 $2.12 $1.71 – 13.7% 3.1% 2.9% 15.3% – 10.2% 2.7% 7.2% 3.3% – 1.4% 1.7% 3.9% 1.6% 2.4% 3.4% 8.1% 1.6% 16.9% 2.4% 8.2% 1.9% 7.5% 3.3% 3.0% 3.4% 0.4% 2.5% 4.1% 6.1% 23.9% 5.9% 27.8% 13.2% 12.9% 6.7% 6.6 3.8 2.7 Compound annual return • IT government bonds • TIPS • Treasury bills • Inflation 2.7% 11.1% 2.5% 2.7% – 1.7% 0.1% • TIPS • Inflation

Fixed Income Maturity Risk 1970–2009 Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010 15% 10 5 0 – 5 – 10 Long-term government bond Intermediate-term government bond Short-term government bond 1.4% 6.1% 9.7% – 8.3% – 3.9% – 1.3% • Average rise in price during declining interest rate periods • Average decline in price during rising interest rate periods

Liquidity Risk Average daily stock trading volume as of year-end 2009 Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010 0.58 0 1 2 4 7 mil Large-cap stocks Mid-cap stocks Small-cap stocks 3 7.17 2.36 5 6

Market-Timing Risk The effects of missing the best month of annual returns 1970–2009 Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010 – 40 – 30 – 20 – 10 0 10 20 30 40% Return 1985 1995 2000 2005 1980 1975 1970 • Annual return • Annual return minus best month 1990

Risk & Volatility

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Risk and Volatility
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Stock Diversification Pastperformance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010 1 2 4 6 8 16 30 50 100 1000 Risk • Company risk • Market risk Number of stocks in portfolio
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Risk Tolerance Spectrum© 2010 Morningstar. All Rights Reserved. 3/1/2010 High risk Low risk Small stocks International stocks Large stocks Corporate bonds Government bonds Cash equivalents High return Low return
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Asset Class ReturnsHighs and lows: 1926–2009 Past performance is no guarantee of future results. Each bar shows the range of annual total returns for each asset class over the period 1926–2009. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010 Compound annual return: 11.9% 9.8% 5.4% 5.3% 3.7% Small stocks Large stocks Long-term government bonds Intermediate-term government bonds Treasury bills 150% 100 50 0 – 50 – 100 142.9% – 58.0% – 43.3% – 14.9% – 5.1% 0.0% 14.7% 29.1% 40.4% 54.0%
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Reduction of RiskOver Time 1926–2009 Past performance is no guarantee of future results. Each bar shows the range of compound annual returns for each asset class over the period 1926–2009. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010 Small stocks Large stocks Government bonds Treasury bills – 60 – 30 0 30 60 90 120 150% 1-year Holding period 5-year 20-year 1-year 5-year 20-year 1-year 5-year 20-year 1-year 5-year 20-year Compound annual return: 11.9% 9.8% 5.4% 3.7%
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Risk Versus ReturnStocks, bonds, and bills 1926–2009 Past performance is no guarantee of future results. Risk and return are measured by standard deviation and compound annual return, respectively. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010 14% Return 12 10 8 6 4 2 0 0% Risk 5 10 15 20 25 30 35 Small stocks Large stocks Treasury bills Long-term government bonds Intermediate-term government bonds
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Ibbotson ® SBBI ® Summary statistics 1926–2009 Past performance is no guarantee of future results. *The 1933 small company stock total return was 142.9%. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010 Compound annual return Arithmetic annual return Risk (standard deviation) Large stocks Small stocks* Government bonds Treasury bills Inflation 9.8% 11.9% 5.4% 3.7% 3.0% 11.8% 16.6% 5.8% 3.7% 3.1% 20.5% 32.8% 9.6% 3.1% 4.2% – 90 0 90
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Stock and BondVolatility Varies 1926–2009 Past performance is no guarantee of future results. Monthly returns in percent from 1926–2009. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010 Stocks Bonds 50% 40 30 20 10 0 – 10 – 30 – 20 1926 1946 1966 1986 2006 1926 1946 1966 1986 2006
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Risk Changes OverTime Five-year rolling periods 1926–2009 Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010 0 80 70 60 50 40 30 20 10 90% Standard deviation • Small stocks • Large stocks • Long-term government bonds • Treasury bills Dec 1930 Jan 1926 1940 1936 1950 1946 1960 1956 1970 1966 1980 1976 1990 1986 2000 1996
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Inflation Risk: StocksVersus Fixed Income Range of average inflation-adjusted returns over 20-year periods 1926–2009 Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010 17.2% 4.0% 13.3% 0.8% 8.6% – 3.1% – 3.0% 2.9% Treasury bills Government bonds Large stocks Small stocks 20% Return 15 10 5 – 5 0
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Treasury Inflation-Protected Securities(TIPS) A hedge against inflation,1990–2009 2.7% Annual returns $5 1 30% – 15 Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010 1990 1994 1998 2002 2006 0 Growth of $1 15 $3.65 $3.58 $2.12 $1.71 – 13.7% 3.1% 2.9% 15.3% – 10.2% 2.7% 7.2% 3.3% – 1.4% 1.7% 3.9% 1.6% 2.4% 3.4% 8.1% 1.6% 16.9% 2.4% 8.2% 1.9% 7.5% 3.3% 3.0% 3.4% 0.4% 2.5% 4.1% 6.1% 23.9% 5.9% 27.8% 13.2% 12.9% 6.7% 6.6 3.8 2.7 Compound annual return • IT government bonds • TIPS • Treasury bills • Inflation 2.7% 11.1% 2.5% 2.7% – 1.7% 0.1% • TIPS • Inflation
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Fixed Income MaturityRisk 1970–2009 Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010 15% 10 5 0 – 5 – 10 Long-term government bond Intermediate-term government bond Short-term government bond 1.4% 6.1% 9.7% – 8.3% – 3.9% – 1.3% • Average rise in price during declining interest rate periods • Average decline in price during rising interest rate periods
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Liquidity Risk Averagedaily stock trading volume as of year-end 2009 Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010 0.58 0 1 2 4 7 mil Large-cap stocks Mid-cap stocks Small-cap stocks 3 7.17 2.36 5 6
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Market-Timing Risk Theeffects of missing the best month of annual returns 1970–2009 Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010 – 40 – 30 – 20 – 10 0 10 20 30 40% Return 1985 1995 2000 2005 1980 1975 1970 • Annual return • Annual return minus best month 1990

Editor's Notes

#3 Types of Risk Investors face many different forms of risk depending on the kinds of investments they choose. Industry/company risk: Security values can decline due to negative developments within an industry or company. Market risk: General market fluctuations can affect securities trading in that market. Stocks tend to fluctuate more than other asset classes (such as bonds) and may pose more risk over short periods of time. Credit risk: This is the risk of a bond issuer not being able to make timely payments of principal and interest. The value of a bond may also decrease due to financial difficulties or the declining creditworthiness of the issuer. Interest-rate risk: All bonds tend to rise in value when interest rates fall and to fall in value when interest rates rise. Typically, there is greater price volatility associated with bonds with a longer maturity. Call/reinvestment risk: As interest rates fall, bonds with call provisions may be called in by the issuer prior to maturity. This may leave the investor with the problem of reinvesting the principal at a lower interest rate. Inflation risk: This is also known as purchasing power risk. Inflation is a rise in the general level of prices for goods and services. If investments do not keep up with inflation, an investor’s money will purchase less in the future than it did in the past. Liquidity risk: Some investments may not be widely held by the public and may be difficult to sell if prices drop dramatically. Currency risk: Currency exchange can affect the returns of a foreign security because foreign exchange rates constantly fluctuate with changes in the supply and demand of each country’s currency. Thus, returns achieved by local investors are often quite different from the returns that U.S. investors achieved—even though both are investing in the same security. Political/economic risk: Investments in a foreign country can be affected by the political and economic developments within that country. Market-timing risk: By attempting to time market movements, investors risk being out of the market during the best times and may find themselves jumping into the market during the worst times.
#4 Stock Diversification Diversification is a major benefit of investing in mutual funds. Company or individual security risk is the risk that a specific stock may fall in price due to non-market-related factors such as poor company management. It is the risk in excess of the overall stock market and is not always rewarded with higher returns. You assume greater company risk when you invest in a limited number of securities. Including more securities in a portfolio can reduce the level of company-specific risk you are exposed to. This is true for stocks as well as other types of asset classes. This image illustrates that an investor holding more than 100 stocks assumes very little company risk. Generally, it is impractical for most investors to buy hundreds of individual stocks. Mutual funds are able to reduce company risk because they have economies of scale. With millions of dollars in assets, mutual funds can afford to take positions in hundreds of stocks. Even mutual funds, however, cannot diversify away market risk. Market risk is the risk that the entire market will experience a decline in price. Even if you hold every stock in the market and have very little company-specific risk, you will still be exposed to market risk. Diversification does not eliminate the risk of experiencing investment losses. The portfolios used in this study are equally weighted. Returns and principal invested in stocks are not guaranteed. Mutual funds may have management fees and other additional costs. An investment cannot be made directly in an index. Source: Lawrence Fisher and James H. Lorie, “Some Studies of Variability of Returns on Investments in Common Stocks,” Journal of Business, April 1970; Edwin J. Elton and Martin J. Gruber, “Risk Reduction and Portfolio Size: An Analytical Solution,” Journal of Business, October 1977; and Meir Statman, “How Many Stocks Make a Diversified Portfolio?,” Journal of Financial and Quantitative Analysis, September 1987.
#5 Risk Tolerance Spectrum If you desire high long-term returns, you must be willing to accept the high levels of volatility associated with the types of asset classes that produce such returns. There is a wide spectrum of risk levels among asset classes. Risk is defined as fluctuations in returns from one period to the next. Lower-risk investments, such as cash equivalents (for example, Treasury bills or certificates of deposit), have averaged modest long-term historical returns. Higher-risk investments, such as large, small, and international stocks, have averaged higher returns historically but with more volatility or fluctuations in value. One of the first steps in developing an investment plan is to determine which is most important: return stability or long-term investment performance. Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, while stocks and corporate bonds are not guaranteed. Certificates of deposit are insured and offer a fixed rate of return. Furthermore, small-company stocks are more volatile than large-company stocks, are subject to significant price fluctuations, business risks, and are thinly traded. International investments involve special risks such as fluctuations in currency, foreign taxation, economic and political risks, liquidity risks, and differences in accounting and financial standards.
#6 Asset Class Returns 1926–2009 The highest and lowest return experienced by an asset class provide valuable insight into its demonstrated risk. All assets contain some degree of risk; however, some assets are considered more volatile (riskier) than others. This image illustrates the range of annual returns over the period 1926 through 2009 for five asset classes commonly considered in the asset allocation process. Generally, the safest, most stable asset class has been Treasury bills, as indicated by their narrow range of historical returns. Both intermediate- and long-term government bonds have wider ranges of returns than Treasury bills. This is because longer-maturity bonds are more interest-rate sensitive, resulting in greater price volatility. The asset classes with the greatest range of returns are also the asset classes with the highest compound annual returns: large and small stocks. Although stocks have historically offered higher returns, they have also experienced greater volatility than bonds and Treasury bills. Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, while stocks are not guaranteed and have been more volatile than the other asset classes. Furthermore, small stocks are more volatile than large stocks, are subject to significant price fluctuations and business risks, and are thinly traded. About the data Small stocks are represented by the fifth capitalization quintile of stocks on the NYSE for 1926–1981 and the Dimensional Fund Advisors, Inc. (DFA) U.S. Micro Cap Portfolio thereafter. Large stocks are represented by the Standard & Poor’s 500 ® , which is an unmanaged group of securities and considered to be representative of the stock market in general, long-term government bonds by the 20-year U.S. government bond, intermediate-term government bonds by the five-year U.S. government bond, and Treasury bills by the 30-day U.S. Treasury bill. An investment cannot be made directly in an index.
#7 Reduction of Risk Over Time 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 the range of returns appears 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 one-, five-, 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. During the worst 20-year holding period for stocks since 1926, stocks still posted a positive 20-year compound annual return. However, keep in mind that holding stocks for the long term does not ensure a profitable outcome and that investing in stocks always involves risk, including the possibility of losing the entire investment. Although stockholders can expect more short-term volatility, the risk of holding stocks appears to diminish with time. Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, while stocks are not guaranteed and have been more volatile than the other asset classes. Furthermore, small-company stocks are more volatile than large-company stocks and are subject to significant price fluctuations, business risks, and are thinly traded. About the data Small-company stocks in this example are represented by the fifth capitalization quintile of stocks on the NYSE for 1926–1981 and the performance of the Dimensional Fund Advisors, Inc. (DFA) U.S. Micro Cap Portfolio thereafter. Large-company stocks are represented by the Standard & Poor’s 500 ® , which is an unmanaged group of securities and considered to be representative of the stock market in general. Government bonds are represented by the 20-year U.S. government bond, and Treasury bills by the 30-day U.S. Treasury bill. An investment cannot be made directly in an index. The data assumes reinvestment of all income and does not account for taxes or transaction costs.
#8 Risk Versus Return When developing an asset-allocation policy, it is important to understand the risk and return relationship of the assets being considered. The image illustrates the risk-and-return relationship of five traditional asset classes based on performance over the past 84 years. The asset classes are plotted according to risk, as defined by standard deviation, along the horizontal axis, and compound annual return along the vertical axis. Standard deviation measures the fluctuation of returns around the arithmetic average return of the investment. The higher the standard deviation, the greater the variability (and thus risk) of the investment returns. As expected in an efficient market, asset classes exhibiting higher returns are associated with higher risk. Small stocks have exhibited the highest risk of the asset classes shown. Small stocks’ high volatility, however, has been accompanied by high returns. At the low-risk end of the spectrum are cash equivalent investments. These investments have demonstrated very small fluctuations in principal, but have historically offered lower returns as well. The goal is to select and combine assets in an efficient manner in order to meet your future needs at a risk level you feel comfortable with. Diversification does not eliminate the risk of experiencing investment losses. Government bonds and Treasury bills are guaranteed by the full faith and credit of the United States government as to the timely payment of principal and interest, while stocks are not guaranteed and have been more volatile than the other asset classes. Furthermore, small stocks are more volatile than large stocks, are subject to significant price fluctuations, business risks, and are thinly traded. About the data Small stocks are represented by the fifth capitalization quintile of stocks on the NYSE for 1926–1981 and the performance of the Dimensional Fund Advisors, Inc. (DFA) U.S. Micro Cap Portfolio thereafter. Large stocks are represented by the Standard & Poor’s 500 ® , which is an unmanaged group of securities and considered to be representative of the stock market in general, long-term government bonds by the 20-year U.S. government bond, intermediate-term government bonds by the five-year U.S. government bond, and Treasury bills by 30-day U.S. Treasury bill. An investment cannot be made directly in an index. The data assumes reinvestment of all income and does not account for taxes or transaction costs.
#9 Stocks, Bonds, Bills, and Inflation: Summary statistics 1926–2009 This image summarizes, quantitatively, the risk/return tradeoff 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 84-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 84 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. Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, while stocks are not guaranteed and have been more volatile than the other asset classes. Furthermore, small stocks are more volatile than large stocks and are subject to significant price fluctuations, business risks, and are thinly traded. About the data Small stocks are represented by the fifth capitalization quintile of stocks on the NYSE for 1926–1981 and the performance of the Dimensional Fund Advisors, Inc. (DFA) U.S. Micro Cap Portfolio thereafter. Large stocks are represented by the Standard & Poor’s 500 ® , which is an unmanaged group of securities and considered to be representative of the stock market in general, government bonds by the 20-year U.S. government bond, Treasury bills by the 30-day U.S. Treasury bill, and inflation by the Consumer Price Index. The data assumes reinvestment of all income and does not account for taxes or transaction costs. Underlying data is from the Stocks, Bonds, Bills, and Inflation ® (SBBI ® ) Yearbook , by Roger G. Ibbotson and Rex Sinquefield (updated annually). An investment cannot be made directly in an index.
#10 Stock and Bond Volatility Varies Stocks and bonds have experienced different levels of return over the past 84 years. Although stocks exhibited tremendous volatility before World War II, the stock market has been much less dramatic since that time. Conversely, bonds exhibited stability in earlier periods, but have seen dramatic increases in volatility over the past 29 years. One relationship has remained constant: Stocks have been more volatile than bonds on a month-to-month basis. Over the long term, however, stock investors have been rewarded for assuming this greater volatility. Government bonds are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, while stocks are not guaranteed and have been more volatile than bonds. About the data Stocks are represented by the Standard & Poor’s 500 ® , which is an unmanaged group of securities and considered to be representative of the stock market in general. Bonds are represented by the 20-year U.S. government bond. An investment cannot be made directly in an index. The data assumes reinvestment of all income and does not account for taxes or transaction costs.
#11 Risk Changes Over Time The riskiness of an asset can change over time. This image shows how the risk of four traditional asset classes changed over five-year rolling periods from 1926–2009. Rolling-period returns are a series of overlapping, contiguous periods of returns. In this case, the first rolling period is 1926–1930; the second is 1927–1931, etc. While small stocks and large stocks are more volatile than government bonds and Treasury bills, there are times when assets considered less risky exhibit greater volatility. Notice that government bonds and Treasury bills have been generally more risky since the 1980s than they were in earlier decades. Small stocks, while still the most volatile asset class, were less risky in recent periods than they were in the 1930s. Risk is measured by annualized standard deviation. It measures the fluctuation of returns around the arithmetic average return of the investment. The higher the standard deviation, the greater the variability (and thus risk) of the investment returns. Government bonds and Treasury bills are guaranteed by the full faith and credit of the United States government as to the timely payment of principal and interest, while stocks are not guaranteed and have been more volatile than the other asset classes. Furthermore, small stocks are more volatile than large stocks and are subject to significant price fluctuations, business risks, and are thinly traded. About the data Small stocks are represented by the fifth capitalization quintile of stocks on the NYSE for 1926–1981 and the performance of the Dimensional Fund Advisors, Inc. (DFA) U.S. Micro Cap Portfolio thereafter. Large stocks are represented by the Standard & Poor’s 500 ® , which is an unmanaged group of securities and considered to be representative of the stock market in general, long-term government bonds by the 20-year U.S. government bond, and Treasury bills by the 30-day U.S. Treasury bill. An investment cannot be made directly in an index.
#12 Inflation Risk: Stocks Versus Fixed Income Since inflation most significantly affects investments over the long run, it is important to examine the range of inflation-adjusted average returns for various asset classes over a long-term period. Inflation, the rise in prices, erodes each dollar you earn on your investments. By not considering the negative impact inflation has on investment returns, you could run the risk of overestimating your future purchasing power. This image illustrates the best and worst average inflation-adjusted returns over 20-year rolling periods for small- and large-company stocks, government bonds, and Treasury bills. Rolling-period returns are a series of overlapping, contiguous periods of returns. When examining 20-year rolling periods of returns for annual data that starts in 1926, the first rolling period is 1926–1945, the second rolling period is 1927–1946, the third rolling period is 1928–1947, etc. At their best, fixed-income asset classes have experienced very modest 20-year real (inflation-adjusted) returns: 2.9% for Treasury bills and 8.6% for government bonds. Historically, there have been periods when such assets have shown negative returns over 20 years after accounting for inflation. Stocks, however, have consistently exhibited positive real returns over 20-year periods. By investing in large- or small-company stocks, you would have been better equipped to avoid losing purchasing power over the long run. Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, while stocks are not guaranteed and have been more volatile than other asset classes. Furthermore, small-company stocks are more volatile than large-company stocks and are subject to significant price fluctuations, business risks, and are thinly traded. About the data Small-company stocks are represented by the fifth capitalization quintile of stocks on the NYSE for 1926–1981 and the performance of the Dimensional Fund Advisors, Inc. (DFA) U.S. Micro Cap Portfolio thereafter. Large-company stocks are represented by the Standard & Poor’s 500 ® , which is an unmanaged group of securities and considered to be representative of the stock market in general, government bonds by the 20-year U.S. government bond, and Treasury bills by the 30-day U.S. Treasury bill. An investment cannot be made directly in an index. The returns represents a compound annual return. The data assumes reinvestment of income and does not account for taxes or transaction costs.
#13 Treasury Inflation-Protected Securities (TIPS) Treasury Inflation-Protected Securities, or TIPS, are government-issued bonds that can act as an effective hedge against inflation, giving investors a fairly consistent real rate of return over time. U.S. TIPS were originally offered by the Treasury to give investors a means to protect their bond returns from inflation. These securities, unlike other government bonds, are tied to an inflation index—the consumer price index in the U.S. Both coupon payments and final principal payments are adjusted to account for inflation, thus offering investors a potentially stable real rate of return over the life of the bond. Historically, TIPS have given investors a return above inflation. The top graph shows the growth of a TIPS investment compared to inflation, intermediate-term government bonds, and Treasury bills. During the period studied, TIPS had a compound annual return of 6.6%, compared to 2.7% for inflation. Additionally, the lower graph shows that TIPS have offered annual returns above inflation in 13 out of the last 20 years. Although there is no guarantee that TIPS will continue to offer a return above inflation, historically these investments have demonstrated an ability to do so. Government bonds, Treasury bills, and TIPS are guaranteed by the full faith and credit of the U.S. government as to timely payment of principal and interest. TIPS are subject to unique risks, most notably liquidity risk and inflation risk. About the data Intermediate-term government bonds are represented by the five-year U.S. government bond. TIPS are represented by the Ibbotson Associates TIPS index for 1990–1998 and by the Morningstar TIPS index thereafter. Treasury bills are represented by the 30-day U.S. Treasury bill and inflation by the Consumer Price Index. An investment cannot be made directly in an index. The data assumes reinvestment of all income and does not account for taxes or transaction costs.
#14 Fixed Income Maturity Risk A bond’s riskiness and performance potential are closely tied to its maturity. The longer a bond’s maturity (date when it comes due), the more volatile its price when interest rates rise or fall. This graph illustrates the relationship between the length of a bond’s maturity and its sensitivity to interest rates. When interest rates fall, bond prices rise, and vice versa. The amount of fluctuations when interest rates move is called maturity risk. The greater a bond’s maturity, the greater the maturity risk. For the annual periods 1970 through 2009, each year was categorized as a year when yields rose or a year when yields fell. The price changes during all years when yields rose were then averaged. The same was done for years in which yields declined. The price change was isolated, as opposed to the total return, so that the effect would be more pronounced. Since 1970, bonds of different maturities have reacted differently to interest rate increases or decreases. Shorter maturity bonds have been relatively insensitive to movements in interest rates, dropping an average of –1.3% when interest rates have risen and gaining an average of 1.4% when interest rates have fallen. Bonds with longer maturities have been the most sensitive, dropping an average of –8.3% when interest rates have risen and gaining an average of 9.7% when interest rates have fallen. Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. About the data Short-term government bonds are represented by the one-year U.S. government bond, intermediate-term government bonds by the five-year U.S. government bond and long-term government bonds by the 20-year U.S. government bond. An investment cannot be made directly in an index. The data assumes reinvestment of all income and does not account for taxes or transaction costs.
#15 Liquidity Risk If there is insufficient demand for a security, it may be difficult to sell, causing the price to drop significantly. The image illustrates the average daily trading volume in millions of shares for large-cap, mid-cap, and small-cap stocks. The trading volumes in 2009 for all large-cap, mid-cap and small-cap stocks were assembled and the average daily trading volume for each category was computed. The large-cap stock category had an average trading volume of 7.17 million, significantly higher than the small-cap stock category. Large-cap stock companies are widely held and heavily traded, allowing an investor to more easily sell a position at a desired price. Small-cap stock companies are often very small or micro-cap companies that are not widely held and may not be well known by the public. This makes it more difficult for investors to sell their shares at desired prices, and if prices are declining, investors may not be able to sell their shares at all. Some historical performance results show that the average rate of return for stocks has been higher for small companies than for large. There may be a greater potential for growth with small companies, but investors should be aware that there is also a greater risk of loss. Returns and principal invested in stocks are not guaranteed. Furthermore, small stocks are more volatile than large stocks and are subject to significant price fluctuations, business risks, and are thinly traded. Source: Morningstar.
#16 Market-Timing Risk 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 by showing the effects of missing the one best month on an annual return. Missing the one best month during a year drastically reduced returns. During years when returns were already negative, the effect of missing the best month only exaggerated the loss for the year. In five of the 40 years shown, 1970, 1978, 1984, 1987, and 1994, otherwise positive returns would have been dragged into negative territory by missing the best month. 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. Returns and principal invested in stocks are not guaranteed. About the data Stocks are represented by the Standard & Poor’s 500 ® , which is an unmanaged group of securities and considered to be representative of the stock market in general. An investment cannot be made directly in an index. The data assumes reinvestment of income and does not account for taxes or transaction costs.

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