Probability In Motion
Say "HELLO" to Francis, IFA’s newest probability machine, named after Francis Galton, an English mathematician who was expert in many scientific fields.
(Click here to play the video of Francis in action)
Galton’s probability machine demonstrates how a normal distribution is created through the course of random events. IFA commissioned the creation of Francis to better communicate to investors the probability of outcomes of a portfolio that result from a series of random events such as news stories about a company or about capitalism, in general.
As you can see, the random falling of the beads ultimately forms a normal distribution that is represented by the bell-shaped curve. As you can also see, the distribution of the beads in the photograph bears a striking resemblance to the distribution of 600 monthly returns (50 years) for IFA’s Index Portfolio 100 which is indicated by the red overlay.
Like the random distribution displayed by Francis, Index Portfolio 100 carries a wide range of outcomes or a high standard deviation, but maintains a normal distribution with about a 1.05% average monthly return over the last 600 months, but with much short-term volatility.
We know that markets are moved by news which is both random and unpredictable and this news is rapidly incorporated into stock market prices. The degree to which your investment portfolio is exposed to the equities, and therefore vulnerable to equity market-moving news goes a long way to explain the expected range of outcomes the portfolio will experience. Investment portfolios with higher standard deviations have greater uncertainty of returns, but when properly constructed they carry higher expected returns. This relationship between an investment’s level of risk and its expected return is the classic economic trade-off.
The figures below illustrate the difference between the bell-shaped curves of the 600 monthly returns for the high-risk Index Portfolio 100 which carries a wide range of outcomes versus a low-risk Index Portfolio 10 which carries a narrow range of outcomes. The 100% equity Index Portfolio 100 endured greater price swings than the 20% equity and 80% fixed income allocation of Index Portfolio 10, but had higher returns. Over the 600 months, a dollar invested in Index Portfolio 10 would have grown to $28.53, while a dollar invested in Index Portfolio 100 would have grown to $296.05. This historical data supports the presumption that investors who have higher risk capacities are expected to earn higher returns.
A caveat: be certain that you can handle the wide range of short-term outcomes (volatility) that travels in lock-step with higher returns. Those who liquidated their portfolio in the latter part of 2008 or up to March 9, 2009 have paid a steep price for doubting the resilience of capitalism — especially now that major markets have enjoyed the best July in 70 years and IFA's Index Portfolio 100 has roared back 71.57% (net of fees) since its March 9th, 2009 low!