Documenting Risk: A Long-Run Study

Documenting Risk: A Long-Run Study

One of the best-documented propositions in the field of finance is that, on average, investors have received higher rates of return for bearing greater risk. The most thorough study has been done by Roger Ibbotson and Rex Sinquefield. Their data cover the period 1926 through 1988. Appearances notwithstanding, the table was not designed to show One Manhattan skyline and a series of Eiffel towers. What Ibbotson and Sinquefield did was to take several different investment forms – stocks, bonds and Treasury bills – as well as the consumer price index, and measure the percentage increase or decrease each year for each item. A rectangle was then erected on the baseline to indicate the number of years the return fell between 0 and 5 percent; another rectangle indicated the number of years the returns fell between 5 and 10 percent; and so on, for both positive and negative returns. The result is a chart which shows the dispersion of returns and from which the standard deviation can be calculated.

A quick glance shows that over long periods of time, common stock have, on average, provided relatively generous total rates of return. These returns, including dividends and capital gains, have exceeded by a substantial margin the returns from long-term corporate bonds. The stock returns have also tended to be well in excess of the inflation rate as measured by the annual rate of increase in consumer prices. Thus, stocks have also tended to provide positive “real” rates of return, that is, returns after washing out the effects of inflation. The data show, however, that common-stock returns are highly variable, as indicated by the standard deviation and the range of annual returns, shown in adjacent columns of the table. Returns from equities have ranged from a gain of over 50 percent (in 1933) to a loss of almost the same magnitude (en 1931). Clearly, the extra returns that have been available to investors from stocks have come at the expense of assuming considerably higher risk. Note that small company stocks have provided an even higher rate of return since 1926, but the dispersion (standard deviation) of those returns has been even larger than for equities in general. Again, we see that higher returns have been associated with higher risks.

A long-run study. Photo by Elena

There have been several periods of five years or longer when common stocks have actually produced negative rates of return. The early 1930s were extremely poor for stock-market investors. The early 1970s also produced negative returns. The one-third decline in he broad stock-market averages during October 1987 is the most dramatic change in stock prices during a brief period since 1930s. Still, over the long pull, investors have been rewarded with higher returns for taking on more risks.

The patterns evident in Ibbotson and Sinquefield’s table also appear when the returns and risks of individual stock portfolios are compared. Indeed, the differences that exist in the returns from different funds can be explained almost entirely by differences in the risk they have taken. However, given the rate of return they seek, there are ways in which investors can reduce the risks they take. This brings us to the subject of modern portfolio theory, which has revolutionized the investment thinking of professionals.

Burton G. Malkiel. A Random Walk Down Wall Street, including a life-cycle guide to personal investing. First edition, 1973, by W.W. Norton and company, Inc.