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The Planning Problem


The following is an extract from a video by David Booth, the Chairman of DFA, on Retirement, Risk and Return. In this video Booth discusses the importance of balancing volatility risk and purchasing power risk when investing for retirement. He explains that T-bills have not produced the real returns necessary to preserve living standards over the long haul, and illustrates how investors can manage both types of risk through an appropriate commitment to stocks.


From Dave Booth: Historically, treasury bills have earned about 4% per year, while inflation has been about 3% per year, giving treasury bills a positive real return of about 1% per year. That’s assuming, of course, you don’t pay taxes. If you pay taxes probably your returns from treasuries are closer to zero or even negative.


On the other hand stocks have had real returns of around 6% per year. That would allow for much greater spending than available from investing in treasury bills. Of course buying stocks requires taking investment risk. Therein lays the planning problem. On the one hand we need significant real returns to finance our retirement and maintain our standard of living, but we can’t do that without taking any risk.


The chart in the following table shows annualized real returns from 1927 to 2010 for six different portfolio combinations ranging from 100% stocks to 100% treasury bills. A riskier portfolio holds 100% stocks and the least volatile portfolio holds 100% bonds. Between these extremes lie standard stock-bond allocations such as 20-80, 40-60, 60-40 and 80-20. The index used for stocks is the CRSP index (CRSP stands for the Center for Research Security Prices developed at the University of Chicago).

 


Portfolio Weights

Annualized

Ten Years

CRSP

Index

Treasury

Bills

Return

Pct.

Std

Dev.

Worst

Return

Period

Ending

100

0

6.5

18.9

-39.6

Feb-09

80

20

5.6

15.1

-30.9

Feb-09

60

40

4.5

11.4

-22.0

Nov-78

40

60

3.4

7.7

-17.2

Nov-48

20

80

2.0

4.2

-29.4

Nov-48

0

100

0.6

1.8

-42.1

Feb-51


 

The annualized columns provide summary risk and return statistics for these portfolios over the last 85 years. The inflation adjusted return for Treasury Bills has been 0.60% per year or 60 basis points. The inflation adjusted return for stocks has been 6.48% per year. The standard deviation or the measure of risk has been much greater for stocks (18.86) than for treasury bills (1.81).


There are many different ways to talk about risk. For example, take the worst 10 years for these various portfolio combinations. This is calculated by looking at the 900 or so combinations of 10-year data using monthly returns. Starting with Treasury Bills, the worst real return for Treasury Bills was minus 42%. That was the 10 years ending February 1951. That is of particular interest to us now, because over that time period Treasury Bills returned less than 1% per year while inflation was 6% and we are now back to a situation where Treasury Bills yield below 1%. Turning to stocks, the worst 10 year period in real return for stocks (CRSP index) was minus 39%. That was the 10 years ending February 2009.


It’s not surprising that people are having a lot of concern about stock returns having recently lived through the worst 10-year period ever. But in terms of real returns the worst 10 year experience of Treasury Bills is poorer than the worst 10 year return on stocks. By this measure, the Treasury Bills are riskier than the stocks. Although it might appear to be riskier to accumulate wealth in stocks rather than in Treasury Bills, over longer periods of time precisely the opposite is true.


So we have two different conclusions about risk and return, depending on how we measure risk; whether we use volatility or we look at purchasing power. In terms of the worst 10 year experience, the best outcome in this simple example is really for the portfolio that is 40% invested in the CRSP stock index and 60% invested in Treasury Bills. This doesn’t prove anything, but it does conform to our conviction that most investors require a 60 -70% allocation to stocks to earn the returns that will allow them to meet their long-term goals and objectives.