The 60/40 portfolio has one of the best track records over the past 50 years. It has had positive returns 82 percent of the time over rolling one-year periods, 93 percent of the time over rolling three-year periods, and 99.4 percent of the time over rolling five-year periods. The returns were driven not just by stocks, but also by bonds, which had an average annual return of 7.5 percent from 1976–2019.
Over the past 44 years, it gained over 7,000 percent, and had a maximum drawdown of just 30 percent. But that was then, and this is now.
The average 10-year yield over this time was 6.2 percent. Today it’s 0.69 percent, which is why it is impossible, not unlikely, impossible that forward returns will match those of the past.
For one thing, I don’t think anybody in their right mind is expecting large cap U.S. stocks to deliver double-digit returns given their recent performance and current valuation. More importantly, what makes this performance impossible to replicate is the fact that bonds are now, in all likelihood, going to give you returns of less than 2 percent a year.
It’s for this reason that Jeremy Siegel suggests the 75/25 portfolio is the new 60/40 portfolio. Unfortunately, even a portfolio that takes on more risk is highly unlikely to match the returns we’ve seen in the past.
A simple way to think about where stock market performance comes from is to break it down into three variables — the earnings yield (inverse of the P/E ratio), the dividend yield, and the change in multiple.
Using the S&P 500 as a proxy for stocks, the earnings yield and dividend yield get you roughly to a 6 percent rate of return. The change in multiples is the ultimate wild card here, but I can’t with a straight face say that we should expect to see this expand or contribute to returns over the next 10 years. Said differently, if I had to bet, I’d say that multiple compression will be a drag on returns. For this exercise let’s generously assume that the multiple remains unchanged. Using this admittedly naive model, we’ll use 6 percent as an approximate rate of return for stocks.
Bonds are a much simpler story. The best predictor of future bond returns are current rates. Let’s use 2 percent, which is more than a little generous here.
Putting this altogether, a 60/40 portfolio gets you a 4.6 percent return, significantly lower than the 10.7 percent average annual return. Even using 75/25 bumps you up to a little over 5 percent, less than half the historical rate. With bonds doing 2 percent, allocating 75 percent of your portfolio to stocks, they would need to do 14 percent a year to achieve the 10.7 percent average annual return that a 60/40 portfolio delivered.
So what is an investor to do? You can consider stocks that haven’t performed as well, like value, emerging markets or foreign developed countries. You can consider other asset classes such as gold, commodities or bitcoin. You can consider other strategies like venture capital, private equity or private real estate. You can try to outperform the index.
All of these might help you outperform but, unfortunately, you won’t be the only investor with this idea in mind.
I wish there were easy solutions to this problem. There aren’t. This is the world we live in.
The best answer for most people, the answer that nobody, including myself, wants to hear, is to simply prepare for lower returns. Accepting lower returns is a better idea for most people than trying to bridge the gap by swinging for the fences.
Michael Batnick is the director of research at Ritholtz Wealth Management. The original version of his article can be read at this link: https://bit.ly/3hRjT8J