A majority of people I speak with about investment portfolio risk carry a risk profile of “balanced,” or “growth with income,” or for a lack of a better term, “in the middle.” For many people, these terms are synonymous with the classic 60/40 portfolio (60% stocks and 40% bonds). This blended ratio has had good success in recent history, returning over 10% per year since 1982, but with both stock and bond valuations on the high side, what could we expect to see over the next ten years?
First, let’s examine why so many folks are attracted to a balanced risk model. Often times, it happens by default. Investors can’t stomach the high volatility which comes with owning 100% in stocks, but they still want/need to earn more than a bank account or a 100% fixed income portfolio. Therefore, they find themselves “in the middle.” The bonds provide income for return, as well as low correlation to the stocks. Low correlation is what gives us the diversification benefit. I highly recommend using a risk tolerance questionnaire, similar to riskalyze, to verify the investor’s risk tolerance. Stereotypical age-based risk questionnaires are not satisfactory. Go ahead, click the link and take your own quiz.
Now let’s breakdown what we could expect to see in the future from our simple 60/40 portfolio. When looking at our 60% stock allocation, let’s start with the S&P 500 to keep it simple. Considering the P/E ratio, which measures the price of the stock divided by earnings. It is a way to gauge the cheapness or expensiveness of the market. Historically, the P/E ratio averages around 18, but today it is 22. According to John Hancock, over the last 60 years, when valuations have reached today’s levels, the median price return over the next ten years is 5%. However, the range of outcomes can vary significantly on a one-year basis. For today’s exercise, let’s go with the median price return of 5% plus the dividend yield of approximately 2% for the next ten years, for a total of 7% for stocks.
For for 40% allocation to bonds, let’s use the Barclays Aggregate Bond Index to keep it simple. Today’s yield is approximately 2.38%. A good rule of thumb for return expectations over the next decade would be to simply look at the yield. If our yield is 2.38%, it is reasonable to expect a return of 2.38% over the next 5-10 years, on average. Another hurdle with our bond portfolio is the looming threat of higher interest rates. Higher interest rates results in lower bond prices.
Putting it together, if we expect to earn 7% of our stock allocation of 60% and an expected return of 2.38% on our bond allocation of 40%, our total expected return would be 5.15% per year for the next decade or so. Perhaps this is why Joe Davis of Vanguard said
“Given the fragility of the global economy, Vanguard does not see interest rates being raised above 1% for the foreseeable future. End of the day, it estimates investors can earn 3-6% return next five year via a 60/40 balanced fund.”
Perhaps we can improve on the classic 60/40 stock/bond model. In our example above, we simply used the S&P 500 for stocks and noted the P/E ratio is above 22, one of the most expensive markets in the world. What if we include other areas of the world? International and emerging markets stock indexes are currently trading with much lower P/E ratios compared to the S&P 500, with the MSCI EAFE index under 20 and the MSCI Emerging Markets index under 16. According to Research Associates, their expected 10 year return for the MSCI EAFE is 7.0% plus yield and for the MSCI Emerging Markets it is 8.9% plus yield.
For fixed income we used the Barclays Aggregate Bond index exclusively for our example, which is a high quality index with a low yield. What if we included other areas of the bond market and considered different asset classes altogether to provide low correlation? One way to earn more yield is to take more credit risk, in the form of corporate bonds. But the increase in yield is nominal. Other asset classes such as non-traded REITS (real estate investment trusts) and private lending programs are not bond alternatives, but do offer low correlation to the stock market and potentially much more income in the 6-7% range, depending on the program. If we can carve out a portion of our high quality bonds to include more credit risk and include some alternative investments while maintaining our appropriate risk profile, it can lead to higher expected returns above the 5% in our example above.
My suggestion for readers today is to work with your trusted CFP and analyze your financial plan. What is your risk tolerance? What is a reasonable expectation of your returns over the next ten years? If you are “in the middle,” would a 5% growth rate meet your objectives?
This is not a recommendation of any investment strategy or product. Past performance is not indicative of future results.