The Point Of Low Return
The "60/40 expected real return" is the forward-looking long-run real return of a 60/40 U.S. stock/bond portfolio. Stocks' forward-looking real return is proxied by an average of two measures: (i) smoothed earnings yield, or the inverse of the Shiller P/E and (II) the sum of dividend yield and 1.5% (a proxy for long-run growth rate in earnings per share). Bonds' real yield is the difference of the 10-year Treasury yield and a measure of expected inflation over the next decade. Inflation expectations are proxied by an average of several survey forecasts; before these became available in 1978, statistical estimates are used.
FURTHERMORE, Chris Brightman of Research Affiliates has produced this interesting table on the past returns from such a mix. The first four rows 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.