Tuesday 22 November 2011

Yields and Volatility of Different US Asset Classes

The DIY Income Investor approach involves combining different asset classes, including cash, dividend shares, government bonds, commercial bonds and other similar securities (such as preference shares).

It is instructive to look at how these different asset classes have performed in the past - over the peaks and troughs of the economic cycles. How far can the historical record help us navigate the investment 'snakes and ladders' environment?

A recent analysis from The Vanguard Blog has looked at a number of US asset classes from a total return perspective, rather than simply in terms of potential income (i.e., the yield to maturity on a bond fund, or the dividend yield on an equity fund). An investor looking at total return will be concerned with capital gains and losses, as well as with the income derived from bond interest and stock dividends.

It notes that investors hoping to gain more income by increasing portfolio allocation to higher-yielding bonds or dividend-paying stocks should be aware that portfolio volatility will likely increase as a result.

The graphic below shows the impressive volatility-dampening properties of bonds, which (the article says) "should be carefully taken into consideration when developing a sound investment strategy".

Source: Vanguard Blog

You will need to look at the original article for definitions of the numbers used (mainly indexes of different types). The time period covered by this graph (December 31, 1997–October 31, 2011) was chosen by Vanguard because it encompasses both bull markets and bear markets and illustrates the volatility that accompanied the asset classes in question during times of market volatility. Vanguard say that they have evaluated other time periods, with similar results.

What is most interesting for me is how volatility and total return are linked. REITs have produced the greatest returns - but at the cost of a roller coaster ride in price. However, REITs are required to pass the majority of their earnings on to shareholders in the form of dividends and so may be an attractive choice for income-seeking investors.

Dividend shares have significantly out-performed the wider US share market (note that some of the dividend share data is based, oddly, on the FTSE). What is most noticeable is that the yield from bonds (in this case US Government bonds) has produced quite an attractive return compared to other asset classes, as well as providing a steady upward progression in value.

So, there seems to be a good historical case for a 'mix and match' portfolio to maximise returns and minimise volatility. However, Vanguard does sound a note of caution about Government bonds: "an allocation to a conservative bond fund may provide below-average total returns in the next decade".

I am not a financial advisor and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.

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