ISK, RETURN, AND CORRELATION are the determining factors in efficient portfolios. The efficient frontier and portfolios appearing on the previous page were all constructed using the ten asset series appearing below. The Table 1 presents each series' expected annual return, standard deviation (risk), and historical returns over one, three, five, fifteen, and twenty years.
| TABLE 1 | ||||||||
| Risk and Return | ||||||||
| Annualized Returns (12/31/98) | ||||||||
|---|---|---|---|---|---|---|---|---|
| Asset Series | Expected Annual Return |
Standard Deviation (Risk) |
1 Year |
3 Year |
5 Year |
10 Year |
15 Year |
20 Year |
| Smith Barney 3-Month T-Bill | 6.07% | 0.55 | 5.06% | 5.19% | 5.11% | 5.44% | 6.07% | 7.40% |
| U.S. Intermediate Government Bonds | 9.79% | 5.29 | 10.21% | 6.84% | 6.20% | 8.74% | 9.66% | 9.85% |
| Lehman Bros. Government Bond Index | 10.14% | 5.39 | 9.85% | 7.35% | 7.18% | 9.17% | 10.01% | 10.18% |
| Lehman Bros. Mortgage Bond Index | 10.62% | 5.38 | 6.97% | 7.26% | 7.23% | 9.12% | 10.49% | 10.29% |
| Lehman Bros. Intermediate Corporate Bond Index | 10.09% | 4.44 | 8.30% | 6.87% | 7.17% | 9.19% | 10.00% | 10.32% |
| Lehman Bros. Corporate Bond Index | 11.26% | 6.25 | 8.59% | 7.33% | 7.74% | 9.87% | 11.08% | 10.52% |
| S&P 500 Index | 19.24% | 17.73 | 28.58% | 28.27% | 24.06% | 19.19% | 17.90% | 17.75% |
| S&P 400 Index | 19.01% | 19.94 | 19.12% | 23.37% | 18.85% | 19.29% | 19.35% | N/A |
| S&P 600 Index | 13.19% | 20.78 | -1.31% | 14.37% | 13.23% | 13.19% | N/A | N/A |
| MSCI EAFE Index | 16.88% | 21.06 | 9.31% | 9.50% | 7.23% | 5.85% | 15.01% | 13.76% |
ORRELATION IS THE MOST CRITICAL element in creating efficient portfolios. The lower the correlation between assets, the greater their risk-reducing effect when combined together. On the other hand, assets that are highly correlated add little benefit when held in the same portfolio. Table 2 shows the correlations of the assets used in the previous page. Remember: Correlations range from +1 to -1 with the former being perfect positive correlation and the latter perfect negative correlation. A correlation of 0 indicates no correlation. Assets are always perfectly correlated (+1) with themselves.
| TABLE 2 | ||||||||||
| Correlations | ||||||||||
| SB 3-Mo. T-Bill | U.S. Int. Govt. | LB Govt. Bond Index | LB Mtg. Bond Index | LB Int. Corp. Index | LB Corp. Bond Index | S&P 500 Index | S&P 400 Index | S&P 600 Index | MSCI EAFE | |
|---|---|---|---|---|---|---|---|---|---|---|
| Smith Barney 3-Month T-Bill | 1 | 0.17 | 0.17 | 0.22 | 0.17 | 0.16 | 0.01 | 0 | -0.06 | 0 |
| U.S. Intermediate Government Bonds | 0.17 | 1 | 0.97 | 0.88 | 0.94 | 0.92 | 0.25 | 0.18 | 0.06 | 0.17 |
| Lehman Bros. Government Bond Index | 0.17 | 0.97 | 1 | 0.88 | 0.94 | 0.95 | 0.28 | 0.20 | 0.09 | 0.15 |
| Lehman Bros. Mortgage Bond Index | 0.22 | 0.88 | 0.88 | 1 | 0.90 | 0.92 | 0.28 | 0.22 | 0.12 | 0.15 |
| Lehman Bros. Intermediate Corporate Bond Index | 0.17 | 0.94 | 0.94 | 0.90 | 1 | 0.97 | 0.35 | 0.28 | 0.19 | 0.17 |
| Lehman Bros. Corporate Bond Index | 0.16 | 0.92 | 0.95 | 0.92 | 0.97 | 1 | 0.36 | 0.29 | 0.20 | 0.16 |
| S&P 500 Index | 0.01 | 0.25 | 0.28 | 0.28 | 0.35 | 0.36 | 1 | 0.92 | 0.85 | 0.49 |
| S&P 400 Index | 0 | 0.18 | 0.20 | 0.22 | 0.28 | 0.29 | 0.92 | 1 | 0.94 | 0.45 |
| S&P 600 Index | -0.06 | 0.06 | 0.09 | 0.12 | 0.19 | 0.20 | 0.85 | 0.94 | 1 | 0.41 |
| MSCI EAFE Index | 0 | 0.17 | 0.15 | 0.15 | 0.17 | 0.16 | 0.49 | 0.45 | 0.41 | 1 |
HE FIVE PORTFOLIOS ILLUSTRATED on the previous page were evenly spaced across the risk spectrum of the efficient frontier. Table 3 shows their composition as well as their standard deviations and Sharpe measures. Standard deviation is a measure of risk -- the higher the value, the riskier the portfolio. The Sharpe ratio measures the portfolio's benefit-to-risk ratio. It's an attempt to gauge the additional benefit received for the additional risk assumed. The higher the better.
| TABLE 3 | |||||
| Efficient Portfolio Composition & Risk/Return Measures | |||||
| Portfolios | |||||
|---|---|---|---|---|---|
| Asset Series | Conservative | Income & Growth |
Balanced | Growth | Aggressive |
| Smith Barney 3-Month T-Bill | 99.78% | 9.02% | 0 | 0 | 0 |
| U.S. Intermediate Government Bonds | 0 | 0 | 0 | 0 | 0 |
| Lehman Bros. Government Bond Index | 0 | 0 | 0 | 0 | 0 |
| Lehman Bros. Mortgage Bond Index | 0 | 19.21% | 6.37% | 0 | 0 |
| Lehman Bros. Intermediate Corporate Bond Index | 0 | 57.15% | 0 | 0 | 0 |
| Lehman Bros. Corporate Bond Index | 0 | 0 | 49.07% | 23.50% | 0 |
| S&P 500 Index | 0 | 9.74% | 35.56% | 64.41% | 100% |
| S&P 400 Index | 0 | 0.53% | 0 | 0 | 0 |
| S&P 600 Index | 0.22% | 0 | 0 | 0 | 0 |
| MSCI EAFE Index | 0 | 4.35% | 9.00% | 12.09% | 0 |
| Expected Return | 6.09% | 11.06% | 14.56% | 17.08% | 19.24% |
| Standard Deviation | 0.54 | 4.84 | 9.14 | 13.43 | 17.73 |
| Sharpe Ratio | 0.00 | 9.23 | 28.06 | 49.21 | 112.5 |
