Investments

Shortfall: The forgotten risk

June 02, 2021



1 Horizon Actuarial Services, LLC. Survey of Capital Market Assumptions: 2020 Edition. July 2020. The survey included return assumptions from 39 investment advisors, though some were obtained through published white papers. (Vanguard was among the latter.) Expected 10-year returns across asset classes on average were 27 basis points (bps) lower than in 2019 and 35 bps lower for 20-year returns.



Figure 1. Risk characteristics and expected returns of asset classes
The image is a "heat map" gauging the levels of risk for eight asset categories relative to other asset class categories, from green or low risk to red or high risk with gradations in between. The asset categories are private equity, developed non-U.S. equity, emerging market equity, U.S. equity, U.S. high-yield corporate bonds, emerging market bonds in U.S. dollars, U.S. investment-grade bonds, and cash. The risks used in the comparison are volatility, maximum drawdown, illiquidity, and shortfall risk for a 6%

2 For more details on the methodology and assumptions used for PE performance, please refer to The Role of Private Equity in Strategic Portfolios and The Case for Private Equity at Vanguard.


Figure 2. Probability of exceeding 6% annualized 10-year nominal returns
The image shows the probability of meeting or exceeding annualized returns of 6% over 10 years for eight hypothetical portfolios. Four of the hypothetical portfolios have 70% in equities and 30% in bonds; the other four have 60% in equities and 40% in bonds. The equity portion of each portfolio has either a 0%, 10%, 20%, or 30% allocation in private equity (PE). A 10% PE allocation means 7% of an overall 70/30 portfolio or 6% of an overall 60/40 portfolio is invested in PE. In our analysis, the probability of meeting or exceeding the 6% annualized return target over 10 years ranges from 18% for a 60/40 portfolio with 0% PE to 39% for a 70/30 portfolio with 30% PE.
Figure 3. Probability of exceeding 4% annualized 10-year nominal returns
The image shows the impact of lowering the return expectations to 4% over 10 years. We look again at eight hypothetical portfolios with the same parameters as before. Four of the hypothetical portfolios have 70% in equities and 30% in bonds; the other four have 60% in equities and 40% in bonds. The equity portion of each portfolio has either a 0%, 10%, 20%, or 30% allocation in private equity (PE). A 10% PE allocation means 7% of an overall 70/30 portfolio or 6% of an overall 60/40 portfolio is invested in PE. In our analysis, the probability of meeting or exceeding the 4% annualized return target over 10 years ranges from 53% for a 60/40 portfolio with 0% PE to 75% for a 70/30 portfolio with 30% PE.

Contributors

Global Head of Private Investments
Edward M. Dinucci
Vanguard Insights

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