What we can expect to earn from our holdings of stocks and bonds going forward.
Much has been made of the classic investment strategy that has us buying stocks and bonds with an allocation of our capital of 60% to the former and 40% to the latter. In the last 50 years, the so called “60/40” portfolio has returned an average annual return of 10.7%, beating most other investment strategies by a mile. Even hedge funds with all the technology and brainpower money can buy, have had a difficult time competing against this most simple of investment models. Mainly that has to do with fees, and more specifically paying away a share of the performance, but that is a whole other discussion.
The real culprit in this mystery of superior risk adjusted returns is the bond markets. Whilst lending someone money is supposedly all about credit risk and the borrower being able to pay back our capital, when buying listed bonds, we also take a view on interest rates. More specifically, the instruments we hold will go up and down in value relative to the interest rate at which we bought the security. This is where a lot of complicated maths come in and discounted cash flow models, but holistically it is very simple. If you hold an instrument that is yielding 15% (where interest rates were in the 1980s), think about how much more valuable that very bond would be now when interest rates are at 0%.
It is hence easy to understand where all of our returns have come from as interest rates have steadily dropped to rock bottom, but the real question is what to do now that the free lunch in our bond holdings is well and truly over? That is, unless you think interest rates will continue on their path into further negative territory. However, if Japan is any guide there seems to be a limit to how much investors are willing to pay someone to lend them money. Hence, we must put our trust in equities, and the other gift that keeps on giving. Far be it for me to take a view on where our holdings in General Electric, Deutsche Bank, Sony, and more recently Apple or Tesla go from here. Fact is that the MSCI World Index (as a proxy for global equities) has gone up by an annualised rate of 8.7% (including dividends) in the last 5 decades.
Putting the two together, we can now get a fairly good idea of what the expected return of our classic stock and bond portfolio is to be going forward: 60% times 8.7% plus 40% times 0 equals 5.22%. Then you have management fees, custody and execution costs to say nothing of the risk, that what comes down can also go up. If interest rates were to rise, we could lose a lot of money from holding long dated government or corporate bonds. All in, I would say you are looking at a net return of no better than what the Loch Ness monster told Chef’s parents in that classic South Park (The Succubus) episode: about tree fiddy.