**CLICK TO ENLARGE**To get any particular return in the usual percentage form, just subtract one and multiply by 100. For example, 1.013 is a return of 1.3% ((1.013 -1 )*100). Similarly, 0.971 is a return of -2.9% ((.971-1)*100.

To get the average annualized return over a given period, multiply the returns in the table and take the appropriate root. For example, the stock return over the first 3 years shown would be 1.077*1.101*1.013 = 1.2011. Raise this to the one-third power (i.e. do ^1/3 on your calculator or in Excel) and get 1.063 which is a return of 6.3% annualized.

The next step is to calculate a portfolio return. For example, what would be the return if we had invested 50% in the S&P 500 and 50% of the portfolio in the Barclay's Aggregate Index in 1992? The calculation is straight forward: 0.5* 1.077 + .5 * 1.074 = 1.0755. The average annualized return would have been 7.55%.

Doing this for each year and then calculating the average annualized return as shown above gives an approximation of our return if we had chosen the simple 50/50 allocation.

This 20-year period, of course, is one path and a 50/50 split among two broad asset classes is a very simple asset allocation. Still it is an interesting path because it is the one we actually came down ,and the allocation can be viewed as a starting point. The period included 2 severe market downturns as well as a sharp push higher prior to the dot.com bust. It included an act of terrorism on American soil. There were severe corporate governance problems and the worst economic downturn since the 1930s.

How did simple asset allocations fare during this 20-year period? The following table shows the results:

**CLICK TO ENLARGE**As shown, this was a period where additional risk, i.e. a greater exposure to stocks, didn't result in a significant pick-up in return. But it did make a huge difference in the volatility as shown by the high and low returns. For example, the 80% stock portfolio had a low return of -28. 56% in 2008 compared to the low return of -15.90% on the 50% stock portfolio.

These kinds of exercises are useful, I believe, in deciding on an asset allocation. As mentioned above, it is very easy to bring in additional asset classes. For example, if you're wondering how the portfolio would have done if 10% was invested in small cap value stocks, just get the annual returns for that sector and carry out the calculations as described above.

In my opinion, capturing a good long-term return with your funds allocated for retirement depends on having an asset allocation you can stay with. Bailing out and letting emotions take over the investment process is what ruins many retirement plans.

A good asset allocation model takes into account both returns and volatility. I'm glad you focused on that aspect as well.

ReplyDelete