Tuesday, January 22, 2013

More on the Mean-Variance Portfolio, 1995 to 1999, stocks vs. bonds

More on the 1995-1999 Mean-Variance portfolio, a picture of which was posted earlier, and is reproduced above.

The Mean-Variance Portfolio, stocks vs. bonds, 1995 to 1999, was a fairly ridiculous 90% stocks plus 10% bonds. Compared to today's returns -- and the typical returns in the stock market -- the expected return from this portfolio is absurd: 25%. Risk is absurdly low as well: 5.53%.

The high concentration in stocks in the Mean-Variance portfolio was because (1) stocks performed so exceptionally well during this period;  (2) they did so with relatively low risk; and (3) bonds and stocks were highly correlated.

Stocks averaged returns of 27% a year with risk of just 5.5%. Bonds actually had lower returns, 7.8% a year, and with somewhat higher risk, 6.4%. In addition, adding bonds to stocks added very little -- there was no significant diversification effect: Bonds and stocks were correlated to the tune of 84%.

Stocks did very well during this period because of the internet mania in tech stocks, upgrades to computer systems in anticipation of Year 2000 problems, and the release of liquidity by the Fed in anticipation of a Year 2000 collapse that did not come. Buy on the dip worked then.

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