Your assignment is to review the history of stocks over the past five, ten, twenty-five, fifty, and seventy-five years. How have stocks performed overall? What do stocks add to a portfolio? What disadvantages do stocks have? How can you minimize the disadvantages of stocks, while at the same time enjoying the advantages stocks offer? While stocks may be risky in the short term, they deliver higher risk-adjusted returns in the long term.

What are the major benchmarks or indexes that correspond with stocks? (See Learning Tool 15: Possible Benchmarks for Your Investment Plan). It is likely that you will include stocks in your diversified portfolio, so it is important that you select the major benchmarks you will follow to help you understand how stocks perform.

Generally investors consider stocks more risky than bonds. What do they mean by that? To get an idea of one measure of risk, i.e., volatility, we have some tools to help you. To see graphically the volatility of stocks versus other asset classes, open Learning Tool 23: Return Simulation Worksheet. Go to the “Asset Class Data” tab and use the light blue drop-down boxes to select your asset classes (or you can just use the asset classes listed). Use the dark-blue drop-down boxes to select your time period. Then go to the “Charts” tab. Push the “F9” button to see the impact of standard deviation. What this worksheet does is to build random portfolios with the expected return and standard deviation of the period and asset class chosen. It then assumes that each asset class builds ten different portfolios and those portfolios are run for twenty years. The differences between the ten different portfolios are show in the same colored lines. The more the lines move together, i.e., the more each of the random portfolios move together, the less risky or less volatile the asset class. The more the same colored lines diverge, the more risk or more volatile the asset class. Now compare the portfolios for large capitalization stocks, small capitalization stocks, and international. You may get a sense for the volatility in this asset class. 

You have reviewed the historical asset class performance. It is now time for you to estimate your expected return for your Plan for Stage 1 and Stage 2. This process takes three steps:

Now that you have your asset allocation targets, you need to get an idea of how that allocation would have done using historical data and your proposed asset allocation. To get this historical return, use Learning Tool 27: Expected Return Simulation and Benchmarks and include this as Exhibit 1. Using the light blue drop-down boxes, include the asset classes that you are interested in. Using the dark blue drop-down boxes, include the time periods over which you are interested. For example, a Period of 80 means that you are using the last 80 years of data ending in 2006 and calculating the geometric return for that asset class. Note that your choice of time periods will have a significant effect on the historical data. I generally recommend that investor’s use the longest time period available.

After you have put in your allocations and time periods, the Learning Tool will give you a weighted return using historical data. I encourage you to change the time periods to see what impact that has on returns. Determine your weighted return for Stage 1 and 2, your periods before and during retirement.

Finally, adjust the expected returns from the Learning Tool to take into account current market conditions. I strongly recommend that if your weighted return is greater than 10% you use an expected return of less than 10% (6-9%). I also recommend that your expected return for Stage 2 or retirement be less than your expected return on Stage 1. Determine your Expected Return and put these in your Plan in Sections I.A.1. and I.A.2.

To calculate risk, instead of using standard deviation, beta, or other measure of risk, we have simplified the plan to state that we accept the risk of our weighted benchmarks. Copy your allocations from Section III.B.1. and II.B.2 to the sections on Risk in Section I.B.1. and I.B.2.