All assets classes have risk and return characteristics. Although historic returns are not forward-looking and are not expected returns, by examining the historic performance we can gain an understanding of the likely characteristics of a particular asset class.
Returns of Major Asset Classes
The examination of an 83-year period from 1926 to 2008 provides investors with annual return data which is often used an expected mean return for the assets classes. The major asset classes have produced the following annual nominal returns for the United States:
- US Large Company Stocks: 9.6%
- US Small Company Stocks: 11.7%
- US Long-term Corporate Bonds: 5.9%
- US Long-term Government Bonds: 5.7%
- US Treasury Bills: 4.0%
Over this period of 83-years, the US inflation rate has averaged 3.0%. However, inflation has varied widely and therefore the use of real, inflation-adjusted returns are more appropriate particularly when comparing asset class returns globally.
Using data from 1900 to 2008, an examination can be made of nominal versus real returns global asset classes. In nominal terms, world equities returned 8.4% and world bonds returned 4.8%. The corresponding real returns are 5.2% and 1.8% respectively.
Risk of Major Asset Classes
We cannot examine returns without also examining the associated risk to each asset class. Risk, in this context, is measured by a standard deviation metric. By examining the United States nominal returns over the period 1926 to 2008 we observe the following standard deviations:
- US Large Company Stocks: 20.6%
- US Small Company Stocks: 33.0%
- US Long-term Corporate Bonds: 8.4%
- US Long-term Government Bonds: 9.4%
- US Treasury Bills: 3.1%
Using nominal world data from 1900 to 2008, we note the standard deviation for world equities is 17.3% and 8.6% for world bonds.
A risk-return tradeoff refers to the relationship between risk and return. Typically, if you want to achieve a higher return, you must accept a higher level of risk. Reviewing the US nominal asset class data, it can be noted that small company stocks delivered the highest return over the period (11.7%) but also had the highest risk (33.0%).
The risk premium is defined as the extra returns investors can expect for assuming additional risk after accounting for the nominal risk-free interest rate. The world equity risk premium over bonds is 3.4% – that is the additional return investors can hope to achieve from equities over bonds due to the additional equity risk.
Other Investment Characteristics
By making use of a mean and standard deviation when evaluating asset class characteristics, an assumption of a normal distribution of returns is made. However, within a financial market context, an assumption of normality is flawed as returns are not normally distributed. The probability of extreme events is greater than a normal distribution suggests. An examination of the skewness and kurtosis of a distribution is required.
Skewness is a measure of the asymmetry of a return distribution. If more returns are concentrated on the right of the distribution, the returns are said to be positively skewed and conversely for a negatively skewed distribution. Stock returns tend to be negatively skewed.
Kurtosis refers to the “fat tails” of the distribution. That is the greater probability of extreme events than would ordinarily be assumed by a normal distribution.
Although not a function of the return distribution, liquidity is an important market factor which contributes to the risk of an investment. Liquidity tends to be of more concern in emerging markets than developed markets due to smaller trading volumes in those markets and is also of concern for potentially more risky asset classes like low credit quality corporate bonds.
Skewness is most likely:
A. A measure of the asymmetry of the probability distribution
B. A measure of the “tailedness” of the probability distribution
C. A measure that is used to quantify the amount of variation or dispersion of a set of data values
The correct answer is A.
Skewness is a measure of the asymmetry of a return distribution.
Option B is incorrect. It is the definition of kurtosis.
Option C is incorrect. It is the definition of standard deviation.
Reading 52 LOS 52c:
Describe characteristics of the major asset classes that investors consider in forming portfolios