For decades investors have relied on a simple and practical investment approach, the “60/40 portfolio,” to achieve long-term investment goals. The simplicity is elegant and historical results, powerful. In its most simplified form, the 60/40 portfolio is 60% large-cap U.S. stocks and 40% U.S. government bonds.
The American Association of Individual Investors, or AAII, has done extensive research on this approach. The data shows that this allocation has historically held up well against a variety of more complex strategies. Retirement periods lasting upwards of 40 years utilizing this simplified approach and withdrawing 4% annually for income have been successful 87% of the time (i.e., they don’t run out of money). For retirement periods lasting between 15 to 35 years those odds approach the 100% mark. Not bad results!
But there is trouble brewing for this seemingly perfect approach to investing. Earlier this year, in response to COVID, the Fed cut interest rates. This is a lever often used during difficult economic times. What makes this time different is that rates were already very low with the 10-year Treasury hovering just below 2% at the beginning of 2020. That rate is now 0.92%.
So why is this a problem? First, if you are buying bonds in this low-rate environment you will get a low income. Second, current interest rates and the value of your bonds move in opposite directions. If rates go up, your bond value goes down, potentially producing a negative total return for the ‘safe’ portion of the portfolio.
Couple this with a bull market long-in-the-tooth and you have potentially, in the case of the traditional 60/40 mix, a portfolio where all investments could produce negative returns. Gone will be the days of bonds buffering short-term stock market declines and stocks producing double digit returns, or at least that is according to a growing number of professionals on the matter.
So, what is an investor to do? Google “60/40 is dead” and you will find no shortage of blogs and articles defining the problem and confidently outlining strategies to combat this potential threat. The popular options to replace bonds are: Increase your stock allocation or introduce “alternatives” which are non-traditional securities, such as real estate, commodities, private equity and leveraged loans. The concept is these asset classes will zig when the market zags.
These alternative asset classes may have low correlation to U.S. stocks, but they are not without their pitfalls and might not work quite like bonds to help combat volatility. For example, the Vanguard Strategic Alternatives Fund was down almost 18% during the March selloff and Invesco’s Global Private Equity Fund down 47%. Bonds meanwhile were off one percent.
Adding risk is not the answer. We prefer making some small changes on the margins; perhaps introduce shorter-term bonds to soften the interest rate risk and increase international exposure if concerned about future U.S. stock market performance. But don’t throw the baby out with the bath water.
There have been countless studies on human behavior as it relates to finance. What we are seeing now is our ingrained desire to write the script. If we want more control, better to focus on things we actually can control. Instead of trying to find complicated and riskier solutions, investors should be adjusting their expectations to a potentially lower return environment and maintain proper risk.
By adopting a more conservative outlook, investors can plan and ensure cash flow needs are still met, even under the worst of circumstances. If it looks like you will not meet your goals under difficult market conditions, then control the narrative by making hard decisions. These might include working a little longer, cutting back on expenses or holding off on taking Social Security until later in life. These are tough choices, but at least you will be in the driver’s seat.