It is important to understand how the various asset classes have performed historically. Remember than an asset class is a group of financial assets with similar risk and return characteristics. From a historical analysis, we can learn much about a particular asset class.

I believe it is important to study history; including the history of investments and investment returns. Some have wondered why it is important to learn an asset class’s performance history because they reason that the future will not be like the past. President Gordon B. Hinckley stated the following regarding this notion:

All of us need to be reminded of the past. It is from history that we gain knowledge which can save us from repeating mistakes and on which we can build for the future. (“Reach with a Rescuing Hand,” New Era, July 1997, 4)

As President Hinckley said, the purpose of understanding history is to help us gain knowledge, to help keep us from repeating the same mistakes made in the past, and to help us build a foundation on which we can build for the future. In essence, to help us be better stewards.

What have been the characteristics of risk and return historically? If you look at Chart 2, you will see that from 1925 to 2006, large-capitalization stocks (as represented by the Standard and Poor’s 500 Index) have yielded a return of about 10 percent per year and have a standard deviation of about 20 percent. Small-cap stocks have yielded a return of about 13 percent per year and have a standard deviation of approximately 30 percent. T-bonds have yielded a return of above 5 percent per year and have a standard deviation that is slightly less than 10 percent. T-bills have yielded a return of about 3 percent per year and have a standard deviation of about 3 percent as well. Note that while different asset classes have different risk and return relationships, there is generally a positive relationship between risk and return.

Chart 2. Annual Risk versus Return from 1925 to 2006

Chart 3. S&P 500 Annual Returns

Chart 4. Five-Year Annual Returns

If you look at Chart 3, which shows the S&P 500 annual return since 1925, you will see that the annual return appears to be very volatile. There are many years of high returns and many years of negative returns. However, if you look at the return in terms of five-year periods instead of one-year periods, you will notice that there are only three major periods of time on the chart that show a negative return (see Chart 4). If you follow the return trend over a ten-year period, you will likewise see that there have been very few times when the ten-year return was not positive (see Chart 5).

Chart 5. Ten-Year Annual Returns

We will now look at risk, or standard deviation. In Table 1, you will see the geometric return and the standard deviation for each of the major asset classes. As you look at the large-cap return and risk, note that over five, ten, twenty-five, fifty, and seventy-five years, return was never less than 10 percent, even though the standard deviation has ranged from approximately 16 percent to 24 percent.

Source: Ibbotson Associates, Morgan Stanley Capital International

NA = not available

If you look at small-cap returns over the periods of time shown in Table 1, you will see that they have yielded a return ranging from 13 percent to 16 percent; notice that the risk levels of small-cap returns are between 17 percent and 34 percent.

If you look at fixed-income investments (T-bonds), you will see that they have, on average, yielded a return ranging from 1.2 percent up to 11 percent; the standard deviation for T-bonds during this time period was between 8.1 percent and 10.3 percent.

If you look at T-bills on the chart, you will see that they have yielded a range of approximately 2.3 to 5.3 percent interest over the various periods of time; T-bills have had a standard deviation of between 0.1 and 0.9 percent.

Inflation (as measured by the CPI) has been between 2.0 and 4.1 percent with a standard deviation of between 0.9 and 1.1 percent.

In order to invest successfully, you must understand the risks and benefits of each of the major asset classes. This section has attempted to share some risk and return history over the past eighty years.