Given the huge opportunity cost of allocating to cash or bonds at current yield levels, even generally optimistic return assumptions for stocks are enough to keep portfolio level returns near 0% real. The goal of this post is to set the stage for a future post where I hope to share potential solutions that may improve potential returns with a similar risk profile as a traditional 60/40 and to set proper expectations of what a 60/40 allocation dragged down by low yields may provide.
After-tax real return forecasts (see below for the formula used in the calculation)
Stocks
- Let's say you assume stocks will return 6% nominal going forward.
- After tax returns (assuming gains are taxed at the more favorable 20% capital gains tax rate) = 4.8% (6% x [1 - 20%])
- After tax after inflation returns assuming a forecasted 2% inflation rate = ~2.8% (4.8% - 2.0%)
Bonds
- Bonds will generally (best case scenario) return their yield (current yield to worst of the Barclays Aggregate Bond index = 2.0%)
- After tax returns assuming the less favorable rate applied to coupons (and a 35% tax rate) = 1.4% (2% x [1 - 35%])
- After tax after inflation returns assuming the forecasted 2% inflation rate = ~-0.6% (1.4% - 2.0%)
60/40
- 60% Stocks = 2.8% x 60% = 1.68% contribution
- 40% Bonds = -0.6% x 40% = -0.24% contribution
- Total return = 1.45% real
Initial takeaways
The math above outlines the importance of:
- Shielding returns from taxes whenever possible
- Keeping fees as low as possible (or ensuring you get something for your fees)
- Seeking alternative sources of return (whether through allocation or alternative asset classes that now have a very low hurdle rate relative to bonds to be included)
- Minimizing an allocation to negative real return asset classes