Transcript Historical Performance of Financial Assets

Historical Performance of
Financial Assets
What are our investment alternatives?
How have stocks, bonds, cash, and other
financial assets performed in terms of risk
and return?
Why is a global perspective on investing
important?
How does historical performance influence
the asset allocation decision?
Historical Performance of
Financial Assets
Investment alternatives?
Real vs. financial?
Capital Market vs. Money Market?
Equity:
US
Foreign (ADRs)
Mutual Funds
Historical Performance of
Financial Assets
Investment alternatives?
Fixed Income:
US Treasury securities (notes, bonds)
US Agency Securities (FNMA, FHLB, FHA)
Municipal Bonds (GO vs. Revenue, tax issues)
Corporate Bonds (collateral, subordination, etc.)
Preferred Stock (tax issues)
International Bonds (domestic, Euro, Yankee)
Historical Performance of
Financial Assets
Investment alternatives?
Cash Equivalents
Savings Accounts
CDs
T-bills
Commercial Paper
MMMF
Historical Performance of
Financial Assets
Investment alternatives?
Derivatives
Options (calls, puts, warrants)
Futures (financial, commodity, index)
Real Estate
Precious Metals
Art
Historical Performance of
Financial Assets
Issues which should matter in return
performance
Risk!
Seniority of claim (bonds vs. stock)
Business risk
Financial risk
Liquidity!
Secondary market issues
Historical Performance of
Financial Assets
 Ibbotson and Sinquefield (I&S) examined nominal and
real rates of return for seven major classes of assets in
the United States
1. Large-company common stocks
2. Small-capitalization common stocks
3. Long-term U.S. government bonds
4. Long-term corporate bonds
5. Intermediate-term U.S. Treasury bills
6. U.S. Treasury bills
7. Consumer goods (inflation)
Basic Series: Historical
Highlights (1926 - 1998)
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
GEOMETRIC ROR
Large Stocks
Small Stocks
LT Corporate Bonds
LT US Gov’t Bonds
US Tbills
CPI
 Other markets?
11.2%
12.4
5.8
5.3
3.8
3.1
ARITHMETIC ROR
13.2%
17.4
6.1
5.7
3.8
3.2
STANDARD DEVIATION
20.3%
33.8
8.6
9.2
3.2
4.5
Importance of the Global
Perspective
 1. Absolute and relative sizes of U.S. and foreign
markets for stocks and bonds
U.S. = about 52% of total value of securities
More opportunities globally
 2. Rates of return available on non-U.S. securities often
exceed U.S. Securities
Higher returns on equities are justified by higher growth rates
for the countries where they are issued
 3. Diversification with foreign securities can reduce
portfolio risk
Importance of the Global Perspective:
Market Size, $2.3 Trillion in 1969
Other Equity
Venture Capital 11%
0%
Japan Equity
2%
U.S. Equity
31%
Dollar Bonds
1%
U.S. Bonds
21%
Cash Equivalent
7%
Japan Bonds
1%
Other Bonds
14%
U.S. Real Estate
12%
Importance of the Global Perspective:
Market Size, $49.1 Trillion in 1997
Japan Equity
5%
All Other Equity
15%
U.S. Equity
21%
Private Markets
0%
Cash Equivalent
4%
Emerging Market
Equity
1%
U.S. Real Estate
5%
All Other Bonds
18%
Emerging Debt
Market
2%
High Yield Bonds
1%
Japan Bonds
8%
Dollar Bonds
20%
Importance of the Global Perspective:
Better Returns in Bonds? (1987-1996)
Domestic Return
US $ Return
E-rate Return
Canada
10.89
10.98
0.01
France
10.52
12.73
2.00
Germany
7.41
9.79
2.22
Japan
6.49
9.90
3.20
UK
11.30
12.91
1.45
US
8.10
8.10
0.00
Importance of the Global Perspective: Better
Equity Returns? (1986-1997)
Australia
Australia
Canada
Canada
France
France
Germany
Germany
Italy
Italy
Japan
Japan
Netherlands
Netherlands
Spain
Spain
Sweden
Sweden
Switzerland
Switzerland
United
Kingdom
United
Kingdom
United States
United States
Europe
Europe
Pacific
Basin
Pacific
Basin
Europe and
Pacific
Europe
and
North AmericaPacific
North America
World
a World
LOCAL CURRENCY
U.S. DOLLARS
LOCAL CURRENCY
U.S. DOLLARSa
Percent
Ranka a Percent
Rank a
Percent
Rank
Percent
15.5
7
(6)
16.2
10 Rank
(8)
15.5
7
(6)
16.2
10
11.1
13 (10)
11.1
15 (11)(8)
11.1
(10) 17.4
11.1
(11)
15.4
813 (7)
515 (5)
15.4 14 8 (11)(7) 13.7
17.4
11.0
13 5(10)(5)
11.0
14 (11)
13.7
13 (10)
13.9
11
(9)
13.8
12 (9)
13.9 1711 (12)(9)
13.8
4.8
9.4
1712(12)(9)
4.8
(12) 19.3
9.4
(12)
16.9
317 (3)
317 (3)
16.9
19.3
21.7
2 3 (2)(3)
22
1 3 (1)(3)
21.7
22.1
1 2 (1)(2) 21.622
2 1 (2)(1)
22.1 10 1 (8)(1) 16.8
21.6
14.0
6 2 (6)(2)
14.0
16.8
16.6
510 (5)(8)
18
4 6 (4)(6)
16.6
16.7
4 5 (4)(5) 16.718
7 4 (7)(4)
16.7
4
(4)
16.7
7 (7)
14.8
9
16.5
8
14.8 16 9
16.5
5.7
9.9
16 8
5.7 1516
9.9
10.0
13.1
1416
10.0
13.1
16.4
615
16.4
914
16.4 12 6
16.4
12.4
14.1
11 9
12.4
12
14.1
11
Based
on rank within seventeen countries and areas
a
Based
on rank
(rank
for only
the within
twelveseventeen
countries) countries and areas
(rank for only the twelve countries)
Table 3.2
Importance of the Global Perspective:
Diversification of Risk
 Returns from risky assets can stabilize one another
when held together.
 Why?
Some sources of risk are different (unsystematic)
Some sources of risk are common (systematic)
 Unsystematic sources of risk tend to offset. Only
systematic risk matters in a well diversified portfolio.
Importance of the Global Perspective:
Diversification of Risk (Correlation!)
Australia
Canada
France
Germany
Italy
Japan
Netherlands
Spain
Sweden
Switzerland
United Kingdom
Local Currency
U.S. Dollar
Total Returns
Total Returns
0.53
0.75
0.57
0.49
0.33
0.35
0.69
0.55
0.48
0.64
0.74
0.43
0.73
0.47
0.39
0.26
0.23
0.62
0.47
0.45
0.52
0.62
Source: Computed by authors using FT/S&P-AWI Total Return Indexes.
Supplied by Goldman Sachs & Co.
Importance of the Global Perspective:
Diversification of Risk
FR
DM
JP
SW
U.K.
U.S.
W
CN
.533
.193
.409
.353
.428
.618
.652
Correlation Coefficients for Equity Markets
FR
DM
JP
SW
UK
US
.700
.452
.715
.460
.490
.687
.319
.907
.392
.386
.516
.359
.262
.334
.698
.568
.505
.631
.616
.686
.818
Diversification of Risk: Computing
Covariance and Correlation
Covariance: absolute measure of comovement
between two rate of return series
Correlation: relative measure of comovement
can be positive or negative
can be strong or weak
Example
Importance of the Global Perspective:
Summary
Many opportunities to invest outside the US
May be able to enhance expected return
Opportunity to exploit weaker correlations
among country returns to diversify risk
Asset Allocation and Investment
Objectives
Investment Objectives – the articulation of risk
and return issues;
Risk Tolerance
• depends on many factors (insurance, cash reserves,
dependents, age, time horizon, net worth, income)
Return Objective
• can be absolute (“8% per year”) or relative (“1% above
the S&P”); Can also state return objective as a general
goal
Asset Allocation and Investment
Objectives
 Investment Constraints – 5 classes of constraint
Liquidity Needs
• need for income now? at some specific point in the future?
Time Horizon
• typically, longer time horizon means lower liquidity needs and
higher risk tolerance
Tax Concerns
• taxes must be paid by most investors on current income and on
realized capital gains. Unrealized capital gains allow an
investor to defer a tax liability to a later date.
Legal and Regulatory Factors
Unique Needs and Preferences
Asset Allocation and Investment
Objectives
Given objectives and constraints, portfolio
formation involves:
Asset Allocation - proportions invested by asset class
Equity, Fixed Income, Cash, RE, …
Foreign vs domestic
Security Selection - individual assets chosen to meet
target asset allocation