Thursday, May 12, 2016

Simple diversification and changing return to risk

Diversified may be the only free lunch, but that does not mean that there will not be variations in return and changing return to risk trade-offs over different periods. The chart above shows different stock and bond combinations over the last three years against the same combinations over the last year. There has been a marked increase in risk and decline in return. Over the last three years there generally was no dispersion in volatility and just differences in return. For the last year, there has been more variation in volatility and less difference in returns.

There will be different return and risk combinations based on the strategic allocation between stock and bonds. A difference of only 10% in the strategic allocation can have large changes in either return or risk. Making a decision between a 60/40 and 50/50 mix will matter in a low return or higher volatility environment.

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