Monday, June 13, 2016

The Brutal Math of a 60/40 Portfolio

Think only a bear market can keep returns of a 60/40 near 0%... think again.

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)

  • 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 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% Stocks = 2.8% x 60% = 1.68% contribution 
  • 40% Bonds = -0.6% x 40% = -0.24% contribution 
  • Total return = 1.45% real 
Throw on the ~1% fees many financial advisors charge and/or the lower yields many investors are accepting by taking less duration risk / diversifying U.S. bond exposure to even lower yields abroad and an investor may break through the 0% threshold even with a 6% stock forecast. This coming from an allocation that has a historical standard deviation of roughly 10% over time.

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