This is a challenging time for investors. Thanks to the Zero Interest Rate Policy (ZIRP) of the Federal Reserve, interest rates across the board are low. Short-term rates are almost zero. Safe havens like money market mutual funds (mmmf’s) are yielding about 0.1%. From bankrate.com, the best one-year CDs are only offering 1.38% right now
Other assets like gold are at record highs. Stocks, although down from the peak of October 2007, are not priced cheaply, either. Some people think that bonds are a bubble waiting to be pricked.
In an investing climate like this, one wonders is it worth investing in anything at all. I decided to look at the expected return and risk of various portfolios to see what the upside is today compared to the risk.
The Portfolios
I looked at some simple portfolios holding various amounts of stocks and bonds. The stock/bond mix was 0/100, 25/75 50/50, 75/25 and 100/0.
For these stock and bond portfolios, I used Vanguards Total Stock Market Index Fund (VTSMX) and Total Bond Market Index Fund (VBMFX). These are widely recommended mutual funds for passive investors.
I also looked at the Harry Browne Permanent Portfolio. This consists of 25% each of stocks, gold, bonds and cash. Stocks are VTSMX. Gold is the SPDR Gold Shares ETF (GLD). Bonds are Vanguard Long-Term Treasury Fund (VUSTX). In lieu of cash, I used Vanguard Short-Term Treasury Fund (VFISX) which holds 2-year U.S. Treasury notes.
In addition, I consider an all TIPS portfolio using a 20-Year TIPS bond.
Finally, I considered an all cash portfolio using Vanguard Short-Term Treasury Fund (VFISX).
Information about these Vanguard funds can be found on Vanguard’s Mutual Funds webpage.
Methodology
First, estimate the expected returns for each investment asset based on yields and valuations. Then combine the asset returns to estimate the expected return for each portfolio. Next the risk is estimated using the past volatility of returns. The results are plotted in a chart.
These estimates are not cast in concrete because nobody knows what the future will bring. In a sense they are only guesses. Download the spreadsheet so you can make you own estimates or play what if.
Estimating Returns
First of all, inflation expectations are about 2.5 percent. This is the consensus of economists taken from a Federal Reserve survey. It also corresponds with the bond market’s breakeven inflation rate.
Stock returns were estimated using P/E10 which can be found on this website. The latest value of P/E10=19.8. The estimated long-term stock return using the formula 0.8/PE10 comes to about 4 percent. With 2.5 percent inflation, the nominal return comes to 6.5 percent.
In the long run, gold is expected to pace inflation. So the expected return is just the expected inflation rate, 2.5 percent.
For bonds and bond funds, the expected return is the yield to maturity (YTM), which is published on the Vanguard website.
For Treasury Inflation-Protected Securities (TIPS), the expected real return is the real YTM, which can be calculated by a formula from the coupon rate, years to maturity and the bond price. The Wall Street Journal Market Data Center publishes these numbers for TIPS.
Each portfolio return is then calculated as the weighted sum of its components.
Estimating Risk
The measure of risk used is the expected drawdown. Drawdown is how much you can expect a portfolio to be down from some peak value. Using three standard deviations as the expected variation gives about a 99.7% confidence that the drawdown is within that range.
To find the standard deviations of each portfolio, I used the historical standard deviation over the period 1972 to 2008.
The only exception is for TIPS. I assume that the real YTM will vary between 0 to 4 percent. Then 20-year bond prices were calculated over this range.
Table 1 shows the expected risk and returns for each asset.
| ASSET | REAL RETURN | NOMINAL RETURN | STD DEV |
| VTSMX | 4.00 | 6.50 | 18.45 |
| GOLD | 0.00 | 2.50 | 31.56 |
| 20-YEAR TIPS | 1.80 | 4.30 | 8.00 |
| VUSTX | 1.70 | 4.20 | 11.31 |
| VBMFX | 0.80 | 3.30 | 5.58 |
| VFISX | -1.40 | 1.10 | 2.94 |
Portfolio Risk and Return
Table 2 shows the results for each portfolio.
| 0/100 | 25/75 | 50/50 | 75/25 | 100/0 | HB-NOREBAL | HB-REBAL | TIPS | CASH | |
| VTSMX | 0.00 | 0.25 | 0.50 | 0.75 | 1.00 | 0.25 | 0.25 | 0.00 | 0.00 |
| GOLD | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.25 | 0.25 | 0.00 | 0.00 |
| 20-YEAR TIPS | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 1.00 | 0.00 |
| VUSTX | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.25 | 0.25 | 0.00 | 0.00 |
| VBMFX | 1.00 | 0.75 | 0.50 | 0.25 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 |
| VFISX | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.25 | 0.25 | 0.00 | 1.00 |
| PORTFOLIO | 3.30 | 4.10 | 4.90 | 5.70 | 6.50 | 3.58 | 3.58 | 4.30 | 1.10 |
| REBALANCING RETURN | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 1.50 | 0.00 | 0.00 |
| EXP TOTAL RETURN | 3.30 | 4.10 | 4.90 | 5.70 | 6.50 | 3.58 | 5.08 | 4.30 | 1.10 |
| EXPECTED INFLATION | 2.50 | 2.50 | 2.50 | 2.50 | 2.50 | 2.50 | 2.50 | 2.50 | 2.50 |
| EXP SD | 5.58 | 7.19 | 10.61 | 14.61 | 18.45 | 8.24 | 8.24 | 8 | 2.94 |
| EXP DRAWDOWN | 16.74 | 21.57 | 31.83 | 43.83 | 55.35 | 24.72 | 24.72 | 24.00 | 8.82 |
| EXP TOTAL REAL RETU | 0.80 | 1.60 | 2.40 | 3.20 | 4.00 | 1.08 | 2.58 | 1.80 | -1.40 |
The return vs. return for each portfolio is plotted in the chart in Figure 1.
Analysis
First of all, in this low interest rate environment, expected returns are less than in previous years. For instance, the 100% stock portfolio on the upper right in the chart is only expected to return about 4% real while historically the U.S stock market returned about 7% real.
At the other end of the risk spectrum, the real return of all cash is negative. Cash will not keep up with inflation at these low interest rates.
Next up the risk curve, 100% Total Bond Market offers 0.8% return over inflation, with a potential drawdown of about 16%.
Increasing the amount of stock increases the expected drawdown risk. At 50/50 stocks/bonds the return is only 2.40% above inflation with a risk of loss of about 30%. As my grandmother would sarcastically say, “Such a deal!”
Harry Browne’s Permanent Portfolio (HBPP) in the past had returns about the same as a 50/50 stock/bond portfolio, but with a lower risk. Gold and long-term Treasury bonds tend to zig when stocks are zagging, making the overall portfolio less variable.
But HBPP depends on capturing a re-balancing return to boost its returns. Without re-balancing the return is expected to be a meager 1%. Harry Browne followers need faith that the re-balancing return of about 1.5% will materialize over the long run to give them a 2.5% return, which is still far below its historic 5.5% real return.
No passive portfolio has a magic bullet that makes it immune from the low returns presently being offered.
Will We See Deflation…
We used an Inflation expectation of 2.5% Suppose instead that inflation is zero or even negative over the next few years. The return of bonds don’t look so bad in that case.
Many economists argue that there are forces for deflation in the world economy. Globalization and global wage arbitrage keeps wages low. And there is the de-leveraging of debt in the developed countries which reduces investment, economic growth and the demand for money. But the U.S. government has increased borrowing and spending and the central banks of the world are fighting deflation tooth and nail, aiming for inflation. Will they succeed?
…Or Higher Inflation?
On the other hand, many think that a side-effect of all the government bailouts and ZIRP will be elevated inflation. Suppose that instead of 2.5%, future inflation turns out to be 5% or 10%. In that case, the and longer bonds will do a lot worse, while the TIPS portfolio does not suffer one bit.
If you already downloaded the spreadsheet, try changing the inflation expectation to see what kind of effect it has on the various portfolios. Put in inflation of +10% or -5% and see which portfolios are best or worst under those scenarios.
No Where To Hide
In my more opinion, none of these portfolios are attractive options. The normally safe choice which is all cash loses to inflation each year. The portfolios with stocks have a big downside and a small upside. Some people think gold at $1200 an ounce is in a bubble and overdue for a correction for to $300. Others are sure inflation will pick up, interest rates will rise, and bond holders will get crushed.
Stay The Course…
Bold investors will decide to “stay the course.” This means decide how much downside risk you can tolerate, pick a policy portfolio and then stick with it.
Staying the course, otherwise known as Buy & Hold worked well during the 1980s and 1990s. Before that during the 1970s and since 2000 it has not done has as well.
…Or Wait It Out in Cash?
As mentioned at the top, the reason for the low return expectations is the Federal Reserve’s ZIRP. So one strategy would be to wait for better rates. Eventually interests rates should rise.
With this strategy, instead of sticking to a policy portfolio, the default position is cash, maybe in the form of a CD ladder. At least you get some return and maybe even pace inflation.
How long will you have to wait in a CD ladder? Nobody knows, not even Ben Bernanke, the guy who sets the rates. It could be 6 months, 1 year or, if we end up like Japan, 20 years. Yikes!
But in the meantime some assets, like stocks or gold, may crash creating bargains once again. Perhaps the real yield on long-term TIPS might go back up to 2.5%. Were that to happen, waiting it out in CDs would turn out to have been a good bet.
Recommendation
Unfortunately, I can not make any recommendation at this time. Sometimes there is no good answer. You will have to evaluate the situation and make your own decisions.
If I were being totally objective, I would probably say the best option is to wait it out in a CD Ladder and hope that you keep up with inflation.
Am I following this option myself? No. I am mostly invested in bond funds, with about 10% in equities and a little gold. However I do keep some “dry powder” if some bargain presents itself.
For the record Table 3 shows my current asset allocation. To reduce risk I could sell the stock, gold, long-term bonds and TIPS and move to a CD ladder. But that would reduce my income from interest and dividends.
| Asset Class | Target | Actual |
|---|---|---|
| EQUITY | 10 | 9.7 |
| REAL | 10 | 4.3 |
| LT BONDS | 10 | 11.0 |
| IT BONDS | 10 | 34.1 |
| ST BONDS & CASH | 10 | 19.5 |
| TIPS | 50 | 21.4 |
So, is it worth investing in anything at all? My final verdict is that there are no good investing choices at this time. Be cautious, don’t take excessive risk and wait for better opportunities. As the proverb goes, This too shall pass.
