In this tip, Grok expands on the barbell strategy to increase expected real returns from 1.3% to 3%. (This tip was written in Oct, 2011, so Grok’s inflation numbers may differ from current numbers.)
Investing is risky. In 2008 the S&P 500 lost 37% and Emerging Markets lost more than 50%. From mid 1980 to mid 1981 the 10 year treasury rose 400 bps- a move like that today would cause losses to 10 year treasuries of around 30%. During 1980 the price of Gold was cut in half from $800 to around $400. But at least for bearing all these risks investors can look forward to the prospect of good future expected real (i.e. after inflation) returns, right? Hmmm…maybe NOT!
1) Let’s start with the Vanguard Inflation Protected Securities Fund (VIPSX). It currently has a real yield of -0.32%. Similarly the nominal yield on the Vanguard Intermediate treasury fund is just 0.96%. Year-over-year inflation (August) is currently running at 3.6% and Break-even inflation is around 2%, so the expected real return for the treasury fund looks to be -1% or worse.
2) Now let’s look at the S&P 500. Stock returns have 3 components: dividend yield, dividend growth, and multiple expansion. Let’s take the last component first- Professor Shiller’s irrational exuberance website shows the S&P 500 to have a PE10 multiple of over 20 vs. a long term average of around 16. So the S&P 500 looks fairly richly valued already and future multiple expansion seems unlikely. Turning now to dividend yield, the Vanguard S&P 500 Index (VFINX) has a yield of 2.2%. As far as dividend growth, historically real dividend growth has averaged a bit over 1% (over the last 50 years it’s 1.06%). So a reasonable guess for the future expected real return of the S&P 500 is dividend yield + dividend growth = 2.2% + 1.05% = 3.25%.
3) So if you had 50/50 stock/bond portfolio using these 3 funds you might expect a future real return of about 1.3%- not very enticing compensation for all those investing risks…Let’s see if we can perhaps do a bit better…
4) I Bonds and 30 year TIPs: Instead of VIPSX why not use a combination of IBonds and 30 year TIPs? IBonds have real yield of 0% which is at least not negative. 30 year TIPs are yielding 1.05%. So using a 50/50 mix of these would result in a real yield of 0.53%. Plus IBonds have a nice “Put option” feature. If real rates rise both VIPSX and 30 year TIPs will take a hit (30 year TIPs will get hit more as they have a higher duration). But with I-Bonds you can cash in at par and reinvest at the higher rates. Newly issued TIPs have some optionality as well- they have a “deflation put.” What this means is that TIPs will always guarantee you your full return of nominal principal even if there has been net deflation over the period from their issue date to their maturity date. It’s hard to place a value on these put options embedded in Ibonds and Tips but let’s say for the sake of argument it is worth 25 bps (0.25%). That brings the real return for the Ibonds/Tips mix to 0.78%
5) Similarly instead of the Vanguard Treasury fund yielding less than 1%, why not invest in 7 year PenFed CDs yielding 2.75%? 7 year break-even inflation is about 1.80%, so that’s a real yield of 0.95%. And similar to Ibonds you get a valuable put option. If rates rise you can cash in early (losing just 1 years interest) and reinvest at the higher rates. Again, For the sake off argument let’s assume the put option is worth 0.25% bringing the real yield to 1.2%
6) European equities: Many people are quite negative on Europe right now. Perhaps because of this European stock markets seem to offer better future expected returns than the S&P 500. According to the Economist, the PE10 for European markets is about 12, much lower than the 20 for the S&P 500. Dividend yields are higher as well. VGK, the Vanguard Europe Stock ETF currently yields 5.2%.
So to sum up you have the possibility of multiple expansion and a better dividend yield. Even if dividend growth in Europe is weak, future expected real returns for European Stocks might be 6% or so.
7) Now I wouldn’t advise putting all your equity allocation in Europe. But if one did a 50/50 mix of the US and Europe that would boost the average expected real stock return to 4.625%. And if you use Ibonds, 30 year Tips and CDs for your bond money they should have a positive real return of about 1% bringing the real return figure for the 50/50 portfolio up to 2.8% or more than double the 1.3% we started out with in 3) above.
And finally since your equity portfolio is now a bit better diversified, arguably one could shift ones asset allocation a bit more towards equities with their higher real returns. I think one should be a bit cautious with this line of reasoning- in 2008 international diversification didn’t really pay off. But perhaps one might shift 5% points from bonds to equities. With a 55/45 stock/bond mix, with equities split between US and Europe, and bonds in the Ibonds/30 year TIPs & CD mix the expected real rate of return rises to 3%.
In this world of low expected returns and turbulent markets 3% real return is good enough for me!