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: USForeign (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 AccountsCDsT-billsCommercial PaperMMMF

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 riskFinancial 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)

GEOMETRIC ROR ARITHMETIC ROR STANDARD DEVIATION

Large Stocks 11.2% 13.2% 20.3% Small Stocks 12.4 17.4 33.8 LT Corporate Bonds 5.8 6.1 8.6 LT US Gov’t Bonds 5.3 5.7 9.2 US Tbills 3.8 3.8 3.2 CPI 3.1 3.2 4.5

Other markets?

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

U.S. Equity31%

Cash Equivalent7%

Japan Equity2%

U.S. Real Estate12%

Other Bonds14%

U.S. Bonds21%

Japan Bonds1%

Other Equity11%Venture Capital

0%

Dollar Bonds1%

Importance of the Global Perspective: Market Size, $49.1 Trillion in 1997

Japan Equity5%

All Other Equity15%

Japan Bonds8%

Emerging Debt Market

2%

All Other Bonds18%

High Yield Bonds1%

Dollar Bonds20%

U.S. Real Estate5%

Cash Equivalent4%

Emerging Market Equity

1%

Private Markets0%

U.S. Equity21%

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)

Table 3.2Australia 15.5 7 (6) 16.2 10 (8)Canada 11.1 13 (10) 11.1 15 (11)France 15.4 8 (7) 17.4 5 (5)Germany 11.0 14 (11) 13.7 13 (10)

Italy 13.9 11 (9) 13.8 12 (9)Japan 4.8 17 (12) 9.4 17 (12)Netherlands 16.9 3 (3) 19.3 3 (3)Spain 21.7 2 (2) 22 1 (1)Sweden 22.1 1 (1) 21.6 2 (2)Switzerland 14.0 10 (8) 16.8 6 (6)United Kingdom 16.6 5 (5) 18 4 (4)United States 16.7 4 (4) 16.7 7 (7)

Europe 14.8 9 16.5 8Pacific Basin 5.7 16 9.9 16Europe and Pacific 10.0 15 13.1 14North America 16.4 6 16.4 9World 12.4 12 14.1 11aBased on rank within seventeen countries and areas(rank for only the twelve countries)

Ranka Percent Percent

LOCAL CURRENCY U.S. DOLLARS

Ranka

Australia 15.5 7 (6) 16.2 10 (8)Canada 11.1 13 (10) 11.1 15 (11)France 15.4 8 (7) 17.4 5 (5)Germany 11.0 14 (11) 13.7 13 (10)

Italy 13.9 11 (9) 13.8 12 (9)Japan 4.8 17 (12) 9.4 17 (12)Netherlands 16.9 3 (3) 19.3 3 (3)Spain 21.7 2 (2) 22 1 (1)Sweden 22.1 1 (1) 21.6 2 (2)Switzerland 14.0 10 (8) 16.8 6 (6)United Kingdom 16.6 5 (5) 18 4 (4)United States 16.7 4 (4) 16.7 7 (7)

Europe 14.8 9 16.5 8Pacific Basin 5.7 16 9.9 16Europe and Pacific 10.0 15 13.1 14North America 16.4 6 16.4 9World 12.4 12 14.1 11aBased on rank within seventeen countries and areas(rank for only the twelve countries)

Ranka Percent Percent

LOCAL CURRENCY U.S. DOLLARS

Ranka

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 0.53 0.430.75 0.730.57 0.470.49 0.39

Italy 0.33 0.260.35 0.23

Netherlands 0.69 0.62Spain 0.55 0.47Sweden 0.48 0.45Switzerland 0.64 0.52

0.74 0.62United Kingdom

Japan

Source: Computed by authors using FT/S&P-AWI Total Return Indexes.

Supplied by Goldman Sachs & Co.

CanadaFranceGermany

Total Returns

Local Currency U.S. Dollar

Total Returns

Importance of the Global Perspective: Diversification of Risk

Correlation Coefficients for Equity MarketsCN FR DM JP SW UK US

FR .533DM .193 .700JP .409 .452 .319SW .353 .715 .907 .359U.K. .428 .460 .392 .262 .568U.S. .618 .490 .386 .334 .505 .616W .652 .687 .516 .698 .631 .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 constraintLiquidity 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 toleranceTax 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 FactorsUnique 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