Diversification is important at any time during the market cycle but particularly so during periods of volatility.(GETTY IMAGES)
GETTING YOUR ASSET allocation right is one of the fundamental rules of building a portfolio. Being over- or underweight in a specific asset class could skew your returns or increase your risk.
A 60/40 portfolio, which divides assets between equities and fixed income, is a classic approach to allocation.
At its most basic level, this might be 60% in the S&P 500 and 40% in investment-grade U.S. corporate bonds, says David Koch, senior wealth advisor at Halbert Hargrove.
Experts say the main draw of this strategy is its simplicity.
There are a plethora of mutual and exchange-traded funds that invest in stocks and bonds, making it easy to achieve a 60/40 split, Koch says.
“Set it, forget it and rebalance annually,” he says.
But allocating a retirement portfolio along these lines is not without its wrinkles. Here are four reasons why experts say investors should think twice about following the 60/40 portfolio rule:
“The 60/40 portfolio is no longer a good option for investors to place their entire retirement in because people are living longer and should plan for 20 to 30 years of retirement,” says Daniel Hill, president and CEO of Virginia-based Hill Wealth Strategies. “This has potential to be problematic because as inflation rises, so will expenses when they’re in retirement.”
Hill says holding 60% of assets in stocks and 40% in bonds results in a moderate asset mix. While that exposes investors to less risk than a more aggressive portfolio, returns may not be able to keep pace with inflation.
That could limit investors’ purchasing power once they’re ready to retire. The rule of 110 may be more helpful for shaping allocation.
“The rule of 110 says to take your current age and subtract it from 110, giving you the amount of your portfolio you should invest in equities,” says J. Timothy Corle, president and owner of Tycor Benefit Administrators.
A 30-something, for example, would invest 80% in stocks and 20% in bonds using this rule. But it’s not foolproof, Corle says.
“You should be buying equities using a dollar-cost averaging technique throughout your savings years,” he says.
Dollar-cost average is an investing strategy, in which an investor buys an investment for the same amount of money on a consistent basis. The goal is to minimize volatility by investing in the market on a continuous basis as it moves through ups and downs.
Corle also advises: “Use bonds or fixed income in low amounts only if you think you may have a cash need prior to retirement.”
Diversification is important at any time during the market cycle but particularly so during periods of volatility.
Koch says a 60/40 mix of stocks and bonds is not diversified enough for someone who is heading into retirement and will soon be living off their portfolio.
“What if both U.S. stocks and U.S. bonds simultaneously have a bad year?” Koch says. “That’s where adding nonmarket related investments into a portfolio really has its advantages.”
Matthew Peck, a certified financial planner and partner at SHP Financial in Plymouth, Massachusetts, says to consider the entire universe of investments. Real estate, for example, doesn’t historically correlate to market movements and can be a strong hedge against volatility.
Both real estate investment trusts, known as REITs, and direct property ownership can provide continuous income when stocks or bonds falter. Peck also favors alternatives investments and annuities, which have become a more attractive risk hedge.
“There’s nothing magic about the 60/40 portfolio,” says Steve Parrish, an adjunct professor at The American College of Financial Services. “If you own a 60/40 basket of small-cap stocks and junk bonds, you’ve done little to provide downside protection.”
A changing market environment could challenge 60/40 investors if it widens the correlation gap between stocks and bonds.
While stocks are riding high, the stock market is coming off several months of marked volatility. Bond yields have reached all-time lows following the inversion of the U.S. Treasury yield curve, resulting in an increasingly negative correlation with stocks.
The market may be trending bullish but bear markets are the main problem with a simple asset allocation strategy, says Ken Moraif, senior advisor at Money Matters in Dallas.
“The 2008 bear market saw the S&P 500 index fall 57%; the 60/40 portfolio would have lost only 37%,” Moraif says. “While a 37% loss is better than a 57% loss, it’s still more than an investor who is retired or retiring soon could tolerate.”
In terms of 60/40 portfolio historical returns, a portfolio composed of the S&P 500 and 10-year U.S. Treasurys has averaged a 9% return annually since 1928, according to DataTrek Research. That return shrinks to 5.9% when inflation is factored.
Even when markets are up, investors may be no better off.
“This model doesn’t perform well during the up years in the market due to the drag on performance by the 40% bond allocation,” says Matt Nadeau, a chartered financial analyst at Piershale Financial Group in Barrington, Illinois.
The 60/40 model’s assumption that bonds are safe has been challenged of late.
“In the past, investors were able to rely on income provided by their bond investments to support their portfolios during periods of market stress,” says Adam Phillips, director of portfolio strategy at EP Wealth Advisors in Torrance, California. “Unfortunately, today’s low-yield environment means the diversification benefit from bonds will not be as large as in the past.”
While a plain vanilla portfolio may be easier to manage, it’s not necessarily in investors’ best interest in today’s market, Phillips says.
Parrish says portfolio allocation means more than just targeting an arbitrary mix of stocks and bonds. Investment quality, tax effects and timing also matter, as does time horizon. Relying on general investment rules of thumb can put investors at a disadvantage when they don’t account for specific needs, goals or life stages.
Investors who choose to maintain a 60/40 portfolio can take steps to curb risk while potentially strengthening returns.
“One suggestion would be to stay on the lower end of the yield curve, which means having lower duration bonds,” Peck says. “These carry less risk to protect you from your worst fears or if the Fed just slowly raises rates to more normal levels.”
On the stock side, investors can increase diversification by investing across large-cap, mid-cap, small-cap and international markets. It all comes back to where an investor is on the path to retirement.
“The biggest thing with a 60/40 portfolio, assuming you are at the proper age to have such an allocation, is to focus on changing the equity and bond components as the time horizon shortens from more growth-oriented holdings to more income-generating holdings,” Corle says. “Not all stocks and bonds are the same, so make sure you have the correct mix of each type to meet your objectives, whatever your time horizon.”
For more information or questions, please contact Halbert Hargrove at firstname.lastname@example.org.