The Future of the Balanced Portfolio
This is an updated take on a blog that Nick wrote back in 2017, but the information has become all the more valuable as we have begun this new decade. It is not very often that an investor ends up holding either 100% stock or 100% fixed income. Oftentimes after assessing their risk tolerance, it is decided that they should be somewhere in the middle. As a result, we have some sort of balance between our percentage of stocks compared to bonds. The true “balanced” portfolio is one with 60% stock and 40% bond, so that is the one we will look at today.
What Does the Future Hold?
As investors we have enjoyed a wonderful ride over the last 11 years with an annualized S&P 500 return of over 11.5% from January, 2010 to the end of 2020. As we look forward, many analysts believe that this cannot continue due to the extraordinary P/E ratio that the S&P 500 currently displays. The current P/E ratio sits at 34.6 which is one of the highest ratios we have seen since the turn of the century. In fact, the average P/E ratio historically sits right around 18. In essence, the P/E ratio measures how much you must pay for a stock per $1 that the company earns. Therefore, a high P/E ratio means that you are paying more per $1 that the company actually earns. Because of this high ratio, some analysts believe this points to the market being too overvalued, and thus they do not believe it can continue down this path. Bank of America has even gone as far as predicting that over the next decade, we will see a return of -0.8% for the S&P 500. This is the first time Bank of America has put out such a prediction since the tech bubble at the turn of the century.
Stocks are one part of the portfolio, but what about bonds? As of today, the anticipated 10 year bond yield comes in at 1.39%. When we put this into our traditional balanced portfolio what is the result? Well let’s assume a -0.8% return for the S&P 500, plus the current dividend yield of 1.30%. This brings us to a total return of 0.5% for the 60% of your portfolio that is stocks, and a 1.39% return for the 40% that is bonds. This gives us a total anticipated return of 0.86% for the next 10 years in a balanced portfolio invested in the S&P 500 and the aggregate bond index.
What Do We Do?
There are a few key things that you can consider to improve your earnings. Continuing to systematically save could be a major factor in increasing your earnings. If the market goes down, and you continue to purchase the market, then naturally your average cost basis will decrease as well. This way when the market recovers you will earn more over the long-term because of the lowered average basis. If there is one thing we know about the market, it is that it will not be a steady ride forever. Continuing to contribute to your portfolio even when the market is down will help the results of your portfolio dramatically once the market comes back up.
Another opportunity is to diversify your investments even further than purchasing the indices I mentioned. Research Affiliates is projecting better returns for international markets such as EAFE (Europe, Australasia, and the Middle East) where they anticipate a 3.8% return plus the dividends, or a 5.6% return in emerging markets equity plus the dividends. Granted, these investments have a higher volatility and should only make up a portion of your total portfolio, but they represent other opportunities. Additionally, you could continue to invest domestically but invest in alternative investments instead. One example is a Real Estate Investment Trust (REIT) which is projected to have an appreciation of 1% over the next 10 years, but they also pay out an average dividend of 4.3% for a total return of 5.3%. Continued diversification, while maintaining an appropriate level of risk based on your tolerance, can lead to improved returns compared to the 0.86% we calculated earlier.
My recommendation is that you sit down with your CFP® to analyze your current situation, and to discuss your portfolio with them. Discuss your risk tolerance, what returns you can expect, and analyze if those returns would allow you to reach your goals. If you would like to discuss your situation with Peak Wealth Management you can give us a call at (734) 681-7575 or email me directly at preston@peakwm.com
*This is not a recommendation of any investment strategy or product. Past performance is not indicative of future results.