There are many ways to model expected returns. Unfortunately, not one is even close to being foolproof, which inspires looking at multiple measures of market activity. That includes monitoring relative returns through time among the major asset classes, one of several analytical tools employed in the search for strategic perspective in each issue of The Beta Investment Report.
As a basic example, consider the chart below, which graphs differences in rolling 3-year annualized total returns between U.S. stocks (Russell 3000) and U.S. bonds (Barclays Aggregate), foreign stocks (MSCI EAFE) and REITs (Wilshire REITs). For instance, for the three years through the end of June 2009, the Russell 3000 suffers an annualized 8.3% loss vs. a gain of 6.4% for the Barclays U.S. Aggregate Bond Index. The result is that equities are under water by nearly 15 percentage points relative to bonds (red line). By comparison, stocks have bested REITs over the past three years, with a positive spread of more than 11 points (green line). Domestic vs. foreign stocks, meanwhile, are generally neck and neck as of the past three years through last month (black line).

What’s the point of looking at returns in this fashion? It offers some perspective on return on a relative basis. No, it’s not a silver bullet, nor does it offer a quick road to easy money. It is, however, valuable when considered in context with other variables.

As for our chart above, what is it telling us? The raw interpretation is that bonds have had a good run but now it’s time to emphasize stocks in a strategic-minded portfolio. Meanwhile, REITs too look like a better deal relative to stocks. As for domestic vs. foreign stocks, the chart above suggests we should be agnostic for the moment, which implies favoring a market-cap-informed asset allocation until more compelling evidence arrives.
Should we run out and alter our portfolios based solely on relative return histories? Of course not. But neither we should ignore such data. As part of a larger, integrated portfolio strategy of analyzing the major asset classes on a variety of metrics, this is but one of several tools. Others include estimating equilibrium risk premiums, tracking dividend yields and interest rates, monitoring volatility and correlation trends, and watching the yield curve, to cite just a few of the productive chores that are part of the analytical routine at The Beta Investment Report.
Alas, there are no easy “solutions” in portfolio strategy. There is, however, lots of hard work waiting for intrepid investors. That’s no surprise in a world where beating Mr. Market on a risk-adjusted, long-term basis is tough. If you’re inclined to try, there’s no shortage of paths that may lead to nirvana. But be careful: there are many potholes on these highways and the progress in creating a smoother ride comes slowly. To the extent it comes at all, it begins with strategic perspective.
–James Picerno, editor, and The Beta Investment Report (