The point of low return, part two

By Buttonwood

FURTHER to the last post on the expected returns from a 60/40 equity bond US portfolio, Chris Brightman of Research Affiliates has produced this interesting table on the past returns

from such a mix. The first four row cover long periods between 1871 and 2010, the rest relate to decadal returns.

Note the benefits of diversification as shown by the smoothness of the nominal returns; there are no negative decades. Over the entire period, a 60/40 mix has returned 7.6% nominal or 5.4% real. There were only two decades of negative real returns for equities - the 1910s and the 2000s. In the latter decade, diversified investors were cushioned by their substantial gains on their bond portfolios. The former decade was marked by the First World War and unexpected inflation and so was dismal all around. Diversification didn't work in the 1970s either when the second worst real return for bonds was accompanied by the third worst decade for shares; again inflation was the culprit.

Here is the rub. If the way of getting out of the debt trap is for central banks to tolerate higher inflation (and that does seem to be the direction in which we are heading) it seems likely that the returns for diversified investors will be poor. While equities offer a better hedge against inflation than bonds, they are still not a good one; investors will want a higher dividend yield at 5% inflation than they do at 2% inflation. Other things being equal, a shift in the yield from 2% to 4% means a halving in share prices. So although dividends might rise in nominal terms, the market will have to run hard to stay in the same place.

One more thing to note. In nominal terms, the 1980s and 1990s were the two best decades for the 60/40 split, both almost double the historic average. They were followed by the third worst decade. But reversion to the mean may not be over if the AQR chart is correct.