2011 IBF Reference Series: Stock Commentary Common stocks represent a fractional ownership of a company. Historically, stocks have outperformed bonds, but there is no free ride: stocks typically exhibit about twice the risk level of long-term bonds, returns are far less predictable, stock losses of 10-50% or more are not uncommon and a stock investor can hold stocks for a decade and still experience a loss (e.g., from 2000-2009, the S&P 500 had a -0.9% annualized return). Risk (volatility as measured by standard deviation) Standard deviation is the most commonly used measurement of investment risk. One standard deviation shows the expected range of returns for the next 2 out of 3 years. For example, small cap stocks averaged 3.2% from 2006-2010 and had a standard deviation of 23%. This means the projected return for the next 2 out of 3 years is expected to be 3.2% +/- 23% (or a range of +26.2% down to -19.8%). The higher the standard deviation the wider the dispersion and less predictable the return.
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Annualized Returns Can Be Misleading There is often a big difference between an investment’s annualized returns and what it experiences on a year-by-year basis. Annualized return figures can create a false sense of security and a certain level of expected predictability. For example, over the 10-year period 2001-2010, large stocks (the S&P 500) averaged 1.4% per year, yet the closest year to matching 1.4% was 2005, when large stocks returned 4.9% (a 250% difference). All other 9 years saw returns even more varied from the annualized return of 2001-2010.
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Ways To Reduce Stock Risk The risk of investing in common stocks can be broken down into two parts: systematic risk and unsystematic risk. Unsystematic risk represents risks unique to a corporation: its market share, name recognition, management, innovation, sales, reputation, profit margin, etc. This type of risk can be eliminated by owning a large basket of stocks in several industry groups. This type of risk can also be eliminated by investing in a well-diversified ETF, mutual fund or variable annuity subaccount. Depending upon the study cited, unsystematic risk represents anywhere from 20-60% of the “risk pie.”
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The remaining risk, known as systematic risk cannot be eliminated through stock diversification. The only way to reduce systematic risk is by including other asset categories such as bonds, real estate and cash equivalents. By far, the biggest determinant of an investor’s long-term returns and risk is the amount of the portfolio devoted to equities (e.g., stocks, real estate and commodities) and what percentage is invested in fixed income (e.g., bonds, bank CDs, fixed-rate annuities, etc.). For example, the S&P 500 declined 37% in 2008 (its worst year since 1931). However, a 50/50 portfolio (S&P 500 and long-term U.S. Government bonds) suffered a loss of just 10% for 2008. Tax Considerations Under current tax law, securities (e.g., stocks, bonds, mutual funds and ETFs) qualify for long-term capital gains treatment: federal income taxation at either 0% or 15%, depending upon the investor's tax bracket. Generally, stocks are more tax efficient than government or corporate bonds. For example, a popular S&P 500 index fund had a total return of 14.9% for the 2010 calendar year; a 14.6% net return after paying federal taxes on the fund's distributions for the year— a tax efficiency of 98% (note: assumes taxpayer was in the highest possible bracket). All of the performance figures are from Lipper and Morningstar (and represent mutual fund categories) with the exception of this page and its reverse side, which contains information from Ibbotson. Commentary information on this page and the reverse side of this page is from the Institute of Business & Finance (IBF).
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2011 IBF Reference Series: Bond Commentary Bonds are debt instruments; an IOU issued by a corporation, municipality or government. Historically, long-term bonds have exhibited roughly half the risk level of common stocks. However, risk (standard deviation) between these two broad investment categories can be quite wide or narrow, depending upon the period cited, the type of stock or bond and the bond’s duration (maturity). Volatility (risk) For example, during 2010, long-term U.S. Government bonds (20-year maturity) had a standard deviation of 13%, while large cap U.S. stocks (S&P 500) had a 22% standard deviation and medium-term U.S. Government bonds (5-year maturity) just 4%. This means long-term government bonds had 41% less risk than large stocks while 5-year government bonds had 82% less risk.
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Loss of Principal Investors are normally attracted to bond funds for safety, income or as a diversification tool. The price of a bond often changes throughout the trading day. Most of the time, a government bond’s price movements over a day, week or month are much smaller than the price change of a stock category or index. The face value of a bond is only promised or guaranteed if the bond is held until maturity. The table below shows the years government bonds lost principal over the past 15 years; a loss occurred roughly 40% of those years. As a side note, the S&P 500 had capital appreciation losses just 4 of those 15 years, but the average loss was 21%.
When U.S. Government Bonds Have Lost Principal [1996-2010] 5-year U.S. Government Bond
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20-year U.S. Government Bond Year of loss
Principal loss
Year of loss
Principal loss
1996
7.4%
1996
3.9%
1.9%
2004
1.1%
2000 2003
3.4% 3.6%
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2006
14.4%
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1999
2009
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average loss
18.3% 8.2%
1999 2005 2006 2009
average loss
7.1% 2.6% 1.5% 4.4%
3.4%
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Reinvestment Risk Although rarely mentioned, how a bond’s interest payments are reinvested will have a big impact on its annualized returns. For example, if a 25-year bond has a 6% yield-to-maturity (y-t-m), one assumes the 6% figure could be compared to another bond or even a stock fund that averaged 6% a year. Such a comparison would only be valid if each bond interest payment is reinvested in something also yielding 6%. Annualized Returns Can Be Misleading There is often a big difference between an investment’s annualized returns and what it experiences on a year-by-year basis. Annualized returns for long-term government bonds from 2001-2010 were 6.6%; the closest annual return was in 2005, when 20-year bonds returned 7.8% (an 18% difference); the biggest gap was in 2008, when the bonds had a total return of 25.9% (a 292% difference). In the case of medium-term government bonds, annualized returns were 5.6%, with the closest year being 2010, when 5-year bonds had a total return of 7.1% (a 27% difference). The biggest gap was in 2008, when 5-year bonds had a total return of 13.1% (a 134% difference).
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Stocks Annualized Returns
9.9% 8.7% 6.2% 0.6%
4.1%
2.0%
2.0%
4.1%
7.2%
6.5%
1.8%
-3.2%
5-year
10-year
15-year
Best Year
Large Cap Stocks
14%
29% (2003)
Mid Cap Stocks
23%
40% (2003)
Small Cap Stocks
26%
Worst Year
Std. Dev.
P/E Ratio
-38% (2008)
19%
14
-39% (2008)
21%
16
23%
16
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2010
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3-year
-36% (2008)
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42% (2003)
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11.2% 8.4%
7.2%
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5.3%
3.6%
3.4%
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2.7%
5.5% 3.5%
-2.5%
-3.8%
-6.7%
3-year
5-year
10-year
15-year
2010
Best Year
Worst Year
Std. Dev.
P/E Ratio
Foreign Large
10%
35% (2003)
-44% (2008)
22%
14
Foreign Mid/Small
22%
52% (2003)
-47% (2008)
24%
15
World Stocks
14%
36% (2003)
-42% (2008)
20%
15
INSTITUTE of BUSINESS & FINANCE Since 1988
Certified Fund Specialist® – CFS® Certified Annuity Specialist® – CAS® Certified Estate Planning Specialist™ – CES™ Certified Income Specialist™ – CIS™ Certified Tax Specialist™ – CTS™ Master of Science in Financial Services – MSFS
Stocks Annualized Returns 14.7%
13.9%
11.7%
11.1%
10.4%
9.9% 8.7%
7.9%
4.7% 2.7%
3-year
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-2.6%
5-year
10-year
Best Year
Emerging Markets
19%
73% (2009)
Pacific Basin (ex Japan)
19%
U.S. Micro Cap
26%
Std. Dev.
P/E Ratio
-54% (2008)
28%
15
78% (2009)
-55% (2008)
29%
16
52% (2003)
-37% (2008)
23%
14
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24.8%
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19.6%
15-year
Worst Year
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2010
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-2.0%
13.6%
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14.7%
9.8%
8.9%
10.5%
11.6%
10.4%
2.0%
0.1% -3.0%
3-year
5-year
10-year
15-year
2010
Best Year
Worst Year
Std. Dev.
P/E Ratio
Metals
42%
67% (2002)
-30% (2008)
39%
31
Natural Resources
19%
50% (2009)
-49% (2008)
29%
17
Real Estate
27%
37% (2003)
-39% (2008)
32%
38
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Bonds Annualized Returns
6.3%
6.2%
5.8%
6.7%
6.5%
6.4%
6.0%
5.4% 4.1%
3.8% 2.7%
3-year
5-year
10-year
15-year
Best Year
Long-Term Government
11%
29% (2008)
Long-Term Municipal
2%
17% (2009)
World Bond
6%
Worst Year
Std. Dev.
Duration
-16% (2009)
14%
15 years
-9% (2008)
6%
8 years
8%
5 years
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2010
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2.5%
-3% (2005)
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15% (2003)
5.2% 4.0%
4.0%
6.0% 4.4%
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3.5%
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5.1%
3-year
5-year
5.1%
4.8%
4.2%
3.7%
10-year
4.8%
15-year
2010
Best Year
Worst Year
Std. Dev.
Duration
Med-Term Government
6%
9% (2002)
2% (2003)
4%
4 years
Short-Term Government
3%
7% (2001)
1% (2004)
2%
2 years
TIPS (inflation protected)
6%
15% (2002)
0% (2006)
8%
6 years
INSTITUTE of BUSINESS & FINANCE Since 1988
Certified Fund Specialist® – CFS® Certified Annuity Specialist® – CAS® Certified Estate Planning Specialist™ – CES™ Certified Income Specialist™ – CIS™ Certified Tax Specialist™ – CTS™ Master of Science in Financial Services – MSFS
Bonds Annualized Returns
11.1% 9.3% 7.6%
7.2%
7.5%
6.7%
7.0% 5.9% 4.0%
3-year
5-year
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2.6%
10-year
Best Year
High-Yield Corporate
14%
47% (2009)
Bank Loan
9%
Emerging Markets Debt
12%
15-year
Worst Year
Std. Dev.
Duration
-26% (2008)
12%
4 years
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2010
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2.5%
3.3%
-30% (2008)
11%
½ year
32% (2009)
-17% (2008)
12%
6 years
7.5%
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42% (2009)
6.8%
7.5%
7.2%
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0.5%
3-year
6.9% 5.9%
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6.1%
6.4%
3.7%
3.8%
10-year
15-year
1.1%
5-year
2010
Best Year
Worst Year
Std. Dev.
Duration
Corporate
11%
19% (2009)
-5% (2008)
9%
9 years
High-Yield Municipal
4%
32% (2009)
-25% (2008)
10%
8 years
Multi-Sector Bond
11%
29% (2009)
-16% (2008)
8%
4 years
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