How Investors Can Get Out of a Low-Return Rut

Bloomberg put a little scare into investors last October when it reported on a Research Affiliates study that found slim odds of making even a 5% real rate of return over the next 10 years with a traditional 60/40 mix of stocks and bond in your 401(k).

The story, “The Next 10 Years Will Be Ugly for Your 401(k),” was meant to be a conversation-starter. Should you increase your risk? Save more money each month? Change up your whole investment plan? Or should you, as the writer warned, “start getting used to disappointment”?

It’s an interesting topic, but hardly a surprise to anyone who has been following the markets.

Things have been awfully good for an awfully long time. Eventually, something’s gotta give — and it could be your bottom line.
The problem today with the ‘buy and hold’ strategy

A traditional stock-bond portfolio is meant to have a negative correlation: When stocks go up, bonds go down. Folks will tell you it’s Investing 101: You use one as a hedge against the other.

But both stocks and bonds are high right now — and it’s been that way for years. That’s making diversification more difficult.

Bond values are up, but yield isn’t.

The 10-year Treasury yield varies, of course, but let’s say for the sake of example that it’s 2.21% (the rate on June 6). If you’re yielding 2.21%, minus 1.6% inflation (the number used in the Research Affiliates report, although currently it’s in the 2% range), you’re looking at less than a 1% real rate of return.

Beyond yield, the only way to enhance the return on bonds is through capital appreciation of the bonds. Almost always, the sole reason bond values rise is due to falling interest rates. We are currently in a low-interest rate environment, and it appears interest rates are more likely to rise over time, as opposed to declining. So, if interest rates rise, bond values could fall, potentially bringing the total return on bonds into negative territory.

As for stocks — we’re in the second-longest bull market in history. But the length of a bull market doesn’t necessarily mean as much as the valuations of the stocks. And right now, the market certainly isn’t cheap.

Various websites (including Multpl.com, which offers monthly numbers) are reporting the price to earnings (P/E) ratio as somewhere between 25 and 26.5. That’s only happened a few times in history: P/E numbers were this high during the 2008 crash and during the Internet bubble of 2000. When stocks are wildly overpriced, it often means the market is due for a correction … or a more dramatic fall. It’s unlikely it can continue at this pace for the next 10 years.

Put this all together, and it means the traditional buy-and-hold, passive investing strategy of loading up on U.S. stocks and bonds isn’t likely to net a significant return over the next six or seven years.
Some alternative strategies

So what can you do?

Instead of relying on passive management, look at tactical strategies that don’t rely on just following the market. For instance, sector rotation or momentum investing can take advantage of trends in the market. Identifying these trends and investing accordingly can often lead to enhanced returns.
Consider moving some money to markets with cheaper valuations. The Research Affiliates data has international and emerging markets outperforming U.S. markets, strictly because they’re less expensive. But if you do that, you’ll likely take on more risk, so …
Balance those moves with other non-traditional investments, things you don’t see in the typical 60/40 stock/bond portfolio. For example, preferred stocks have a decent yield that could offset the effects of rising interest rates; if you hold on to them, they can create a good amount of income. Real estate and commodities tend to move in different ways than the market — they don’t have the same correlation as bonds to the market.

Talk to your financial professional about these and other strategies that could steer your portfolio around a low-return rut. There are still ways to make money out there — you just have to look outside the box of conventional stock/bond investing.