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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