The trade off between Risk and Return is something that will always be talked about when it comes to investing. Unfortunately, while investors seem to indicate that they understand the concept, they normally don’t in reality. This can be due in part to short term focus with long term investments and lots of “noise” from friends, the newspapers, TV, etc that serve to make one second guess themselves all the time.
Let’s Make It Visual
I’ve put together a graphical back test of 10 portfolios that vary in exposure to equities from 10% equity to 100% equity. The 100% equity portfolio is allocated as follows:
15% Emerging Markets
The 90% equity portfolio has 10% exposure to fixed income (which is represented by the DEX Canadian Broad Bond Index). Each of the equity components’ percentage allocation is reduced by 10% accordingly, such that the 90% equity portfolio looks like this:
13.5% Emerging Markets
10.0% Fixed Income
…and so on, until the 10th portfolio is only 10% equities and 90% fixed income and looks like this:
1.5% Emerging Markets
90% Fixed Income
Here is how they each looked from the period of January 1988 until August 2008, assuming annual rebalancing and no transaction costs or other fees:
(Click image to enlarge)
(Graph created using software from DFA Canada Inc.)
The “safest” portfolio which was 90% fixed income would have taken $1 and turned it into $6.04 during this time. The “riskiest” portfolio which was all equity would have taken this $1 and turned it into $7.96. To put this into perspective, consider that this represents an increase of 31.79% of the end amount.
Alternatively, you can think of $100,000 turning into $604,000 versus $796,000.