Everyone knows about the tradeoffs between risk and return. Generally, the more risk you take, the greater the return and vice versa. A way to express this graphically is the classic risk-return chart; returns are along the y-axis and risk is on the x-axis.
The chart below represents the forecast 10-year returns for the major asset classes, including U.S. large cap equities, international and emerging market equities, and U.S. aggregate core bonds (chart and forecasts provided by Research Affiliates, LLC). I removed the axis values for the forecasted returns and risk since I think the most value can be garnered from the relative placement of the dots. Let’s talk about them!
As one would expect, emerging market (EM Equity) and international developed equities (EAFE) (the two red dots in the upper right quadrant) take the prize as having relatively more risk than most all the other major asset classes (along with U.S. small cap and REITs), but they also provide the highest expected returns. U.S. large cap equity, perhaps not unsurprisingly given its phenomenal 10-year run and relatively higher current earnings multiples, shows a much lower relative level of returns despite having only modestly less risk.
Bonds (light blue dots) cover the lower left quadrant forecasting low risk and low return. Again, this is not surprising given the recent historic lows in yields.
The six dark gray dots connected by the dotted line represents “efficient” portfolios of combinations of all the major assets classes. In other words, for a given level of risk, each dot represents a combination of assets that produces an expected return that is superior to any other combination. From an academic perspective, there are many assumptions that cause this framework to be merely a theoretical exercise, but it still provides an interesting thought process.
From this data we can see that a portfolio management approach of diversified investments is superior to any individual asset class for a given level of risk over a long-time horizon. This approach is core to my investment philosophy.
By the way, if you are curious what Research Affiliates has forecasted real returns and risk to be for U.S. Large Cap equities they are -0.5% return and +15.4% standard deviation risk.