- Portfolio A entirely consists of large cap U.S. stocks (S&P 500);
- Portfolio B consists of 7 assets: large-cap US stocks, small-cap US stocks, non-US stocks, real estate, commodities, US bonds, and cash, each class has equal share in the portfolio with annual rebalance.
Now assume you would hold it for 46 years (from 1970 to 2015). Which portfolio do you think would have a better return?
To answer this question, you first need to know how to measure return.
Measures of Return
There are two ways to measure an investment's return - over multiyear period or over a rolling time period.
a. Average Annual Return Over Multiyear Period
This is easy to understand, when you invest $10,000 in 1970, after 46 years, how much you would have in 2015? Based on that amount, you can calculate the average annualized return over the time period.
As shown in the table below, the 46-year average annualized return of large cap U.S. stocks is 10.27%. It outperformed the diversified 7-asset portfolio which only had 9.78% average annual return over the same period.
b. Average Annual Return Over Rolling Period
This method takes into consideration that most investors' investment time horizons are short (although many investor claim to invest for the long term) therefore shorter time horizon's annual returns are more meaningful for most investors.
We will use 3-year and 10-year rolling periods as examples.
During a 3-year rolling period in the past 46 years (total 44 rolling 3-year periods), the large cap U.S. stock portfolio had average annual 3-year rolling return of 10.93%, slightly better than the diversified 7-asset portfolio's average annual 3-year return of 10.30%.
During a 10-year rolling period in the past 46 years (total 37 rolling 3-year periods), the large cap U.S. stock portfolio had average annual 10-year rolling return of 11.10%, again, slightly outperformed the diversified 7-asset portfolio's average annual 10-year return of 10.68%.
Not yet, we have to consider the Risk of the portfolio, which is a more complicated factor, we will discuss in our next blog post.