What caught my eye this week.

Josh Brown is concerned. The financial advisor and TV pundit behind The Reformed Broker blog sees a new kind of fear and greed out there:

The type of fear that now drives most market activity (because it drives most market participants) is something different than the fear we’ve been accustomed to from reading about history.

I would label this type of fear Insecurity. The fear of being left behind and looking like a fool.

Every couple of years Josh – a hyper-connected poet of the markets – sticks a pin on the tail of the donkey of our times.

I think he’s done it again.

Sonic boom boy

It’s true a strange new operating system is running the show these days.

If you spend the unhealthy amount of time that I do taking skin burns from exposure to market radiation, you see it in everything from fallen hedge fund titans bemoaning day-trading nihilists to the world’s best banker getting befuddled about Bitcoin to meme stock madness and the endless back-and-forth shouting of crypto and story stock tribalists.

Not even the purist passive investor can completely duck the fallout. Monevator’s voice of sanity, my co-blogger The Accumulator, has written candidly about his own brush with FOMO:

How do you respond when someone invents something fundamentally new (hello, crypto) that could be a game-changer or a ponzi scheme? […]

If you’re The Accumulator you sit on the sidelines like a hunter-gatherer who can’t believe this farming lark will ever catch on.

Meanwhile, you torture yourself with crypto-millionaire fables – because even a caveman has to have a hobby.

Of course @TA is too chaste to be possessed by the zeitgeist. Instead he just gets the odd hot flush wondering about what might have been if he’d only acted a little crazy, like everyone else.

Boom Shack-A-Lak

Are we at a crescendo of craziness? A decade of gains in the dominant US market has sent its equity valuations into thin air. Meanwhile bonds look priced to do nothing more than fleece your pockets behind your back.

Perhaps we didn’t need overnight crypto billionaires, zero-cost stock trading, and a global pandemic that locked us in front of our computers to whip up this frenzy. But we got all that and more.

No wonder there’s a bit of a riot going on.

There will come a time when all this has passed. The thing to be seen doing will be to shuffle through the virtual town square bemoaning disruptive growth stocks, calling cash king, and flagellating yourself for claiming to have understood how Bitcoin works. Everyone will say never again and some will even mean it.

Eventually memories will die and a few on the fringes will hear a new beat. But that’s a story for another day.

First, last, and always

Indeed I don’t think today’s climate is unprecedented – batshit bonkers though it may feel at times.

It reminds me very strongly of the late 1990s and the Dotcom boom.

I sat that out as an investor. But I was in the mix as a recent-ish graduate with a tech background and exposure to people getting rich quick:

Visiting an old friend at the company, I was amazed to see that many of these formerly artistic types, from the secretaries to my friend in management – now had shortcuts to stock tickers on their desktops.

They were entranced to see themselves become richer by the day  and they watched their share prices like parents cooing over a new baby.

Now let’s be clear: I don’t think we’re in an identical tech bubble right now.

The best companies today really are technology firms. They’re flush with cash and their profits are still galloping higher in a way that textbooks said was near-impossible.

I talked about this reversal on Monevator many years ago. Even today my active portfolio has more in tech than will probably seem wise in retrospect. The shares are expensive, but the companies are genuinely changing world.

No, it’s more that desperate edge to the missing out that Josh identifies that reminds me of the late 1990s.

Your investments are going up, but someone else’s are very publicly doing so at light speed. And that guy you knew from college is already a millionaire on TV. (Or more likely YouTube or TikTok nowadays).

Don’t stop ’til you get enough

Here’s a tiny anecdote from the Dotcom boom that seemed like a bad dream just a few years later, when the West was bogged down in a war in Iraq and we were 36 months into a bear market.

The scene is a beer garden with a couple of mates in West London in 1999. There I am making the case – again – for us quitting our jobs and starting a tech firm.

We’d been in the right place at the right time for what seemed like an eternal four or five years. And everyone was getting rich except us – but that wasn’t actually the worst of it.

No, what I remember feeling was exactly the existential insecurity that Josh talks about in his piece.

It wasn’t so much that there were big opportunities to make money that we felt we were missing out on.

It was a dread sense that this might be the last chance to get ourselves out of the doldrums and into the class of wealth generators apparently being airlifted to a new economy all around us.

History tells us the feeling was mostly nonsense. Lots of those paper fortunes evaporated. I knew founders who were back in a day job by 2001 and I wasn’t even especially startup-adjacent.

But the future didn’t feel like that in that pub in 1999. It was now or never.

Maybe the Dotcom boom was more localized than today’s global mania, which is why I feel this callback where Josh doesn’t.

Do I have antibodies lingering from those times? I hope so!

Okay boom-er

I’m not silly enough to predict an imminent crash. Markets can stay bananas for ages.

But this graphic from John Authers at Bloomberg shows we’re all-in on this together:

If this is your first time around the block, know that markets are bewitchingly cyclical. The next bear market will begin the day most people have forgotten they ever happen.

Enjoy the boom while it lasts, but have a plan or an asset allocation ready for the day when it’s done. (As a very active investor my plan is basically to run for the exits when the time comes before everyone else. I strongly you suggest you have a more sensible one!)

The important thing in the investing game is to keep compounding over the decades. It all adds up eventually. Never risk getting wiped out.

Meanwhile if this is not your first rodeo then you don’t need me to remind you these best of times won’t juice our returns forever.

Except, of course, you probably do…

Have a great weekend!

[continue reading…]

The first page of a Google search for the 60/40 portfolio suggests we have a problem. The headlines claim the 60/40 may need to be ‘rethought’ or ‘may not have a future’. It is no longer ‘good enough’.

So is the 60/40 portfolio dead? Dying? Should you jump ship if you’re sitting in the Vanguard LifeStrategy 60 or some other variant of the 60/40?

Well, there is certainly blood in the water.

As with any online feeding frenzy, the media sharks have sniffed out a few molecules of truth. But the meal they’ve made out of it is a clickbait chowder spiced by unsubstantiated opinion. Washed down with poor advice.

So let’s set aside those empty calories and chew on the heart of the matter.

There are reasons to be fearful. Today we’ll discuss the magnitude of the problem. In part two we’ll walk-through potential remedies.

What is a 60/40 portfolio? The classic 60/40 portfolio is named for its strategic asset allocation that splits into 60% equities and 40% bonds. The equity portion positions investors to benefit from the long-term growth prospects of global stock markets. The inherent risk of equities is offset by a diversifying allocation into high-quality government bonds. The underlying rationale for the 60/40 portfolio was provided by Modern Portfolio Theory. The split soon became a default solution for financial advisors, workplace pension schemes, and DIY investors. The simplicity, historical record, and widespread acceptance of the 60/40 makes it a useful compromise. The allocation puts investors in a reasonable spot on the risk vs reward spectrum – but without exposing the finance industry to accusations of negligence in the event of shortfall or failure.

60/40 portfolio problems

There are good reasons to think the 60/40 portfolio may be under-powered in the current environment.

High stock market valuations have historically been correlated with weaker future returns five to ten years out.

The US stock market dominates global indices. And it keeps pushing into nose-bleed territory – at least according to valuation metrics such as the cyclically-adjusted price-to-earnings (P/E) ratio (CAPE).

Meanwhile, current government bond yield-to-maturities are typically taken to be an indicator of future returns. (The correlation tends to be highest around the seven to ten-year maturity mark).

Bond yields today are still super low.

Taken together, rich valuations for US equities and negative bond real yields (that is, negative after inflation), do not augur a bountiful decade for the 60/40 portfolio.

Managing expectations

The financial industry flashes these warnings about the future via the concept of expected returns.

Usually this takes the form of a 10-year forecast of average annualised returns.

And currently those numbers fall short of the 60/40 portfolio’s historical return.

The predictions look worse still when compared to the golden age of the past decade.

How much worse? In the next two sections:

• I’ll compare the expected returns estimates from some respected sources.
• I’ll show you how to calculate your own expected returns.
• We’ll conclude by talking about how accurate these prophecies are. (Spoiler Alert! Not very).

Expected returns prophesise gloom for the 60/40 portfolio

Below are three forecasts of expected returns for the 60/40 portfolio from credible industry sources. The numbers are 10-year annualised real returns, except where noted.1

Vanguard expected return: 2.6%. (4.6% nominal)

Note that 4.6% is Vanguard’s median nominal expected return for a global portfolio (bonds are 70% US Treasuries). I’ve derived the 2.6% real return by subtracting a 2% annual inflation guesstimate.

Dimson, Marsh, Staunton expected return: 1.6%

The renowned financial professors don’t say what their forecasted range is, or indicate portfolio composition. I’ve previously seen their forecasts predicated on a 20-30 year range, with developed world equities and 20-year gilts.

Research Affiliates expected return: 0.58%

Research Affiliates is a fund manager specialising in risk factor investing. I calculated the number from their expected return tool, based on global equities and gilts.

Do it yourself return hand-waving forecasting

Don’t like these numbers? Then you can calculate your own expected returns for the 60/40 portfolio…

First, let’s compute returns from the equity side of the portfolio.

Step 1 – Use an accepted valuation metric such as the Gordon Equation.

Step 2 – Grab the current dividend yield of the fund that’s the mainstay of your portfolio. (Or the weighted figure for every fund if you want to be super-precise. But it’s probably not worth it.)

For example: the dividend yield (at the time of writing) of the Vanguard FTSE All-World ETF = 1.38%

Step 3 – Add the dividend yield to a consensus real earnings growth number. I’m plugging in 1.4% for the latter, for reasons explained in the Gordon Equation article I linked to above.

So: 1.38% + 1.4% = 2.8% expected annualised return for the equity side (10-year, real return).

Now, let’s do the bonds. They’re even easier.

Step 1 – Get the 10-year gilt yield from FT.com.

Step 2 – That yield is nominal so make it real by subtracting an educated guess about annual average inflation rates.

Again: 1% (10-year gilt yield at time of writing) – 2% (my inflation rate guess) = -1% expected annualised return for the bond side (10-year, real return).

Our 60/40 portfolio’s expected return is the weighted sum of our equity and bond numbers.

• 60% equity allocation = 2.8 x 0.6 = 1.68%
• 40% bond allocation = -1 x 0.4 = -0.4%

Our portfolio expected’s return = 1.28%

Remember that’s an annualised, 10-year, real return.

Many unhappy returns

We now have a range of expected returns:

• 2.6% – Cheers Vanguard!
• 1.6% – The middle-ground from Dimson, Marsh, Staunton.
• 1.28% – We’re glass half-full types at Monevator.
• 0.58% – Research Affiliates is perma-pessimistic on vanilla securities.

The historical average real return for the 60/40 portfolio is 3.4%. Our middle ground forecast cuts that by more than half. That’s not good news.

And it gets even worse if you anchor to the last decade.

The Vanguard LifeStrategy 60 fund is a 60/40 portfolio that delivered 8.9% annualised over the past ten years.

That’s a nominal return. Let’s call it 6.5% after inflation. That’s almost double the historical return!

We hope you enjoyed the ride.

Could the expected return predictions be wrong?

Yes! The one thing you can expect from expected returns is that they will be wrong.

I rounded-up some 2012 and 2013 forecasts in a ye olde Monevator post.

None came close to predicting 6.5% annualised returns for the decade ahead:

Sure, the ten years isn’t up. But in some cases there’s only months to go.

Moreover, these predictions weren’t typically saddled with UK bias or fund fees, unlike the Vanguard LifeStrategy 60.

My co-blogger The Investor can’t resist reminding me that he struck a more optimistic tone when writing in 2012.

But was he skillful, lucky, or is he cherry-picking his prognostications?

Maybe a bit of all three. After all, Vanguard’s research team analysed the predictive power of 15 equity forecasting metrics. They found that the best (CAPE) only explained 43% of the variance in future returns ahead of time.

Thus even CAPE left 57% of the variation unexplained.

It all means expected returns are about as reliable as UK weather forecasts.

At least they remind us that it might rain, so we should pack a brolly as well as our sunnies.

Similarly, we should not blindly assume that the glorious returns of the last decade can carry on. Especially as the downside signals are even more pronounced now than they were ten years ago.

The Bank of England expects

You could argue the expected returns circulating ten years ago were too cautious. But we couldn’t know that at the time. The process was right, despite the outcome.

The warnings today also come from credible figures. They are worth taking seriously, whatever the uncertainty.

Surprises can come in nasty flavours as well as nice. It might turn out that Research Affiliates’ 0.58% is closer to the mark than Vanguard’s 2.6%.

There’s also no law that prevents a 60/40 portfolio losing money for ten years or more.

If you’re spooked, what countermeasures can you take that aren’t counter-productive?

I’ll go through some sensible options in the next post on the 60/40 portfolio.

Suffice to say, there are some terrible ideas being spread around by big media brands. It’d be better if they made a genuine effort to help people.

Take it steady,

The Accumulator

1. Real returns subtract inflation from your ‘nominal’ investment results. Real returns are a more accurate portrayal of your capital growth in relation to purchasing power than standard nominal returns. [↩]

This is the story of how I found myself over the pension Lifetime Allowance (LTA) and what I’m doing about it. It does not constitute investment advice. I use ‘pension’ and ‘SIPP’ interchangeably to mean a Defined Contribution pension. (Sadly, I’ve no experience of Defined Benefit schemes.)

I started with the best of intentions. Sometime back in the 1990s I began putting all my earnings above the higher-rate tax threshold into my pension.

I was fairly sure the higher-rate years wouldn’t last long – my nagging imposter syndrome was itself no phony!

After a while I’d still not been found out. And so with other calls on my money – ISAs, property investment, family – I moderated my contributions.

All told, there was only a few hundred thousand pounds in my SIPP when the £1.8m Lifetime Allowance for pensions was introduced in 2006. So it didn’t seem particularly consequential at the time. There was certainly no urgency to worry about going over the pension lifetime allowance.

The LTA felt even less consequential in the immediate market wreckage of the Global Finance Crisis. Everything was down, including my portfolio.

Pumping up my pension

Fast-forward a few years. Asset prices recovered, and I continued to squirrel away my contributions. The chances of my hitting the LTA increased.

As the tax system got more draconian, I therefore got more tactical. I only contributed to my pension when I was getting an effective 50-60% rate of relief. When paying the ‘additional’ rate, for example, or because of the annual allowance taper or the child benefit claw-back.

It was starting to look like I might be a higher-rate tax payer in my retirement.

Nevertheless, I kept contributing – because who ever knows what’s going to happen?

Psychologically I’d prefer to see money go into my pension – even if it faced an uncertain future – than to see it wiped out today in tax.

Once it’s gone it’s gone, after all.

Allowance down. Portfolio up

I didn’t apply for LTA protection for a couple of reasons. But the main one was that once you take this action, you have to stop contributing.

I had ended up in a job with the sort of arrangement where my employer put in 4% if I put in just 3%. So even if more additions did take me over the LTA, contributing still seemed just about worth it.

By this time they’d cut the allowance to £1.5m. Meanwhile my SIPP was worth about £800,000.

Still plenty of room, you’d think?

Tax tail wags investment dog

What investments did I hold in my SIPP?

Well, US equities.

And why US equities?

Because under the reciprocal tax-treaty, UK pension funds, including SIPPs are treated as tax-free entities by the US tax authorities (the IRS).

Even more amazing, some brokers and custodians are actually sufficiently well organised that they apply the correct rules so that you don’t pay dividend withholding tax on US equities in a SIPP. 

There was a time when this really mattered; when you got a 4% yield on US stocks, that’s a 60bps per annum uplift (15%x4%).

I appreciate that doesn’t sound like much. But it’s £6,000 a year on £1m. Every little counts.

The US equities market is roughly half the world market cap. So I’d keep that half in the SIPP and the other half in ISAs and suchlike.

Even better – you can hold foreign currencies in a SIPP. This means that when your US stock pays dividends, you can re-invest 100% of those dollars back into more US stocks, paying more dividends. All without your broker gouging your eyes out with a currency exchange spread that you could drive a bus through. 

Lovely, you would think.

Or perhaps more an example of being too clever by half?

2016: Under a cloud and over the pension lifetime allowance

All at once, a bad thing and then a very bad thing happened in quick succession.

In April 2016 the LTA was reduced to £1m. That was annoying.

But not half as annoying as what came in June, which, for me personally, was pretty devastating: Brexit.

Sterling, predictably, depreciated sharply. The pound value of my completely US Dollar-denominated SIPP soared up and over the pension lifetime allowance, without even touching the sides.

Not that this was any silver lining to the Referendum result for me. I’d rather live in a rich multi-cultural society and be well-off in hard currency terms, than live in a poor insular one and be nominally rich in a devalued currency.

But apparently not everyone felt the same way.

No point crying over spilt milk

Apart from a brief market swoon in March 2020 – when it looked like my LTA problem might be solved for me – I’ve been well over the pension lifetime allowance ever since.

In retrospect I should have done things differently. Perhaps there are some lessons for the reader in here: 

• I shouldn’t have contributed so much when I was younger. But in my defense, there was no LTA then. So it is, in effect, a bit like retrospective taxation – especially with respect to the 25% tax-free amount. Lesson: don’t trust the government. 

• My wife has fewer pension assets than me. I should have had my employer contribute to my wife’s pension, out of my salary sacrifice. This would have got money into her pension, with tax relief at my marginal rate. I only found out this option when I read about them closing the loophole! Lesson: pay more attention.

• I shouldn’t have concentrated my non-Sterling exposure in my SIPP. But in my defense, what other country in history has voted to devalue its own economy? Lesson: populism doesn’t work for complicated issues.

• I should have changed my asset allocation, maybe in the depths of the March 2020 crash. But in my defense, I didn’t know US equities would go on to nearly double while the world economy largely stayed on its knees. Also rebalancing is difficult. Some of the US-listed ETFs in this portfolio are irreplaceable, because of – cough – an EU rule called PRIIPS. (The irony isn’t lost on me) Lesson: pay more attention, again. 

• I should have given more serious thought to this issue before The Investor asked me to write an article about it a couple of weeks ago. Lesson: pay more attention, again, again. 

I guess the meta-lesson for readers is to start thinking about this issue early.

Where we are today

The value of my SIPP is now far over the pension Lifetime Allowance.

• At the margin it’s a reasonable assumption that gains in my SIPP will eventually incur a 55% LTA charge.

• Outside the SIPP, assets that don’t produce an income will attract a 20% capital gains tax (CGT) rate. 

Let’s first run through the conventional wisdom of what one should do in these circumstances.

Stop contributing 

There’s no point now I’ve hit the LTA – a bit of convoluted maths indicates the 55% penalty rate I’ll pay on taking my money out will at the least undo the 40% tax relief I got putting money in.

But… I’m in an employer’s matching scheme that means it costs me 20p for every £1 in my scheme (up to a fairly low limit).

I’ll get 45p of that, after the LTA charge. 

[Editor’s note: Individual tax situations vary hugely, and the maths may be different for you. Read the comment thread after this article for a good discussion of this!]

Decrease risk in the SIPP

Wise heads say I should concentrate my growth investments outside the SIPP, and just use the SIPP for the bond allocation.

We all hold a 60/40 equity/bond portfolio, right? So I should have the bond bit in the SIPP, high-yielding equities in my ISAs (or my Family Investment Co), and no-yield equities outside of the tax wrappers.

With bond yields where they are, returns from that asset class aren’t going to shoot the lights out after all.

With any luck the LTA will rise with inflation again. Eventually it could catch up with the value of my SIPP, which will have had very little growth in the meantime from those bonds. Heck, I could just leave it in cash. 

This is all fine in theory. But I have a few issues.

Firstly, it assumes that there’s a couple of million pounds outside the SIPP for the equities allocation.

Then there’s psychology. I’ve noticed that it’s easier for me to stomach high volatility in the tax wrappers than outside. There’s some mental accounting, whereby losses in the tax wrappers are somehow less real (and therefore less painful) than losses outside them.

Why? I guess because the funds in tax wrappers won’t be touched for a very long time, if ever. In contrast funds outside are money I could use to pay for groceries or school fees.

Tellingly, my SIPP was my best performing investment account by a country mile for a very long time – and also the least accessible. (Though perhaps this was down to me being (un)lucky. It was only the withholding tax issues drove the asset location decision.)

Finally, rebalancing out bonds into equities from this pot is a problem, should it be required, because we effectively can’t move money out of the SIPP any time soon. 

Increase risk in the SIPP

On the other hand, all losses in the SIPP now effectively get a 55% tax rebate.

Short-dated out-of-the-money call options on a meme stock like AMC? Why not? YOLO! HMRC is going to pick up more than half the tab if it goes bad!

This feels wrong. But I’m still giving it some thought. 

Get a divorce

This would be quite a bit of paperwork, but under certain circumstances pension assets are split on divorce. And my my wife’s pension assets are only about 15% of the way to the LTA…

There’s a point at which divorcing Mrs Finumus and then immediately re-marrying her might save us hundreds of thousands of pounds.

(I’ve not run this one by her yet).

Take the tax-free lump sum as soon as possible 

Taking the tax-free lump sum at least reduces the extent to which the problem is compounding. The trouble is that that’s deemed an LTA benefit crystallisation event. 

Do nothing

Currently, the first mandatory LTA test is at age 75. Fortunately that’s nearly 25 years away for me. It’s possible the rules will change during that time – probably for the worse, but possibly for the better.

The SIPP still has many advantages, including the multi-currency capabilities, the freedom from US withholding tax, and minimal paperwork compared to doing CGT submissions on a trading account.

My SIPP also falls outside my estate for IHT purposes (albeit after paying the LTA charge). 

What have I actually done to my SIPP?

I’m still contributing to my pension to get the matching contributions.

I’m slowly reducing the risk level in my SIPP and increasing risk outside. In fact I’m going to explicitly let my leverage run a little hotter than previously, and offset this with short-term treasuries (essentially cash) in the SIPP. 

And I’m practicing gratitude. I’m acutely aware of how fortunate I am to be in this position. 

Other implications of going over the pension lifetime allowance

I’ve also made some wider changes in light of all this.

Decreased risk in my children’s SIPPs

My children are in their late teens. They’ve had SIPPs since they were born, and various people have made contributions on their behalf, contributing a maximum £3,600 p.a., gross and including basic rate tax relief. (How do they get tax relief when they pay no tax? Don’t ask me.)

These SIPPs are now worth over £100,000 each.

Whilst this still seems like a long way from the LTA, they might be lucky enough to be paying very high marginal tax rates sometime in the future. Compounded growth of all these early contributions might rob them of the opportunity to avoid those high tax rates by contributing themselves – because it will bring them closer to the LTA.

But who knows? They’ll be much regulatory uncertainty over their lifetimes. 

Increased risk in the (grand)parents’ SIPPs

Note: What follows is based on my current, slightly hazy, understanding of the rules.

Now this might seem even more orthogonal to the original problem. But since we’re in the neighborhood anyway, let’s drive by.

Between my wife and I we have three surviving parents. All are comfortably off, all over 75, and all, sadly, mortal.

Each of the three have substantial sums in their SIPPs – which are in ‘flexible drawdown’ – but the sums are far below the LTA threshold.

In addition, in all but the most extreme of circumstances they likely have sufficient assets outside their SIPPs to last them out.

Historically we’ve taken a fairly standard approach to their investments – reducing risk steadily as they have aged and stopped working.

However, my review of the LTA situation suggests a slight change of direction.  

The rules are complicated, but SIPPs can be inherited, fall outside the estate for IHT purposes, and the beneficiaries (in this case because the benefactors will be over 75 on their death) can draw down at their marginal tax rate (it’s treated as regular income for the beneficiaries).

The last time the LTA  ‘benefit crystallisation’ test is applied is on death. The beneficiaries can pass on the SIPP, generation after generation, and weirdly, as soon as one of them dies under age 75, the whole lot can be taken out tax-free by their beneficiaries.

In case you missed it… the last time the LTA test is applied is on the death of the original beneficiaries. 

What does all that mean? Clearly, as a family, we want the high return stuff in the oldies’ SIPPs. In an ideal world they’d be worth exactly the LTA on the day of their demise.

And then? This seems like a gaping loophole… but as I read it the pot can grow tax-free – forever. Theoretically, under the current legislation, you could leave it compounding, untouched, and completely tax-free, for centuries. 

Of course they’ll change the rules long before that. 

Any other ideas?

This has been a classic example of a ‘you only understand it if you can explain it to others’ situation.

Just writing this all down has forced me to properly confront a looming issue that I’d just been sort of ignoring for a while now – that my excess over the pension lifetime allowance isn’t going away, and some mitigation measures are appropriate.

I’m sure there are many other things I could do. Let’s hear some of them in the comments!

If you enjoyed this, follow Finumus on Twitter or read his other articles for Monevator.