Portfolio Design: A Modern Approach to Asset Allocation

STOCKS AND BONDS SINCE 1951

To study stock and bond returns, we will begin by focusing on two series, large company stocks and Treasury bonds. The large-cap series is from SBBI prior to 1974 and from Standard & Poor’s from 1974 to present.3 Both series measure returns on the S&P Composite Index. The S&P Composite Index consists of 500 stocks from 1957 to present and a 90-stock S&P series prior to 1957. The Treasury bond is a 20-year Treasury bond also from SBBI.

Table 2.1 reports the average returns for these two assets. Also included is the one-month Treasury bill, the closest we can come to the risk-free rate of modern portfolio theory. Two averages are reported. The geometric (or compound) average return is the best estimate of the average return earned over this entire period. The arithmetic average is the best (i.e., least unbiased) estimate of next year’s return. Also included in the table is the standard deviation. The averages and standard deviations are both expressed in annualized terms.

There are several notable features of these returns that should be emphasized. First, consider the Treasury bill and bond returns. There is a relatively small gap between the returns on these two series. As a reward for investing in a 20-year bond rather than a one-month Treasury bill, the investor earns an extra 1.2 percent. The 20-year bond has a large standard deviation of 9.5 percent. A one standard deviation band around the average return includes negative returns. Indeed, in 1999, ...