By Justin Carbonneau (@jjcarbonneau) —
Late last year I gave a presentation to investors title, “Alternatives to the 60/40 Stock/Bond Portfolio: Why Investors Should be Thinking About this Now in Today’s Market”. In it, I argued that the traditional 60/40 stock/bond portfolio, which had been a simple, cheap and highly effective way for balanced investors to build wealth, had the potential to disappoint over the next decade, and investors seeking returns should be considering alternatives both in terms of asset classes and strategies as well as other important financial adjustments.
In this article, I’ll outline the case I made and why it’s important for balanced investors to think about this in today’s market.
The Big Idea
I started the presentation with the Big Idea of my talk:
| The 60/40 stock and bond portfolio has been a winning investment strategy for the last 30+ years for those investors looking to balance risk and return. As a result, it has become the dominant asset allocation for most investors in or nearing retirement. However, high stock valuations and low bond yields may be headwinds for the 60/40 over the next decade, and lower expected returns from the portfolio could pose significant problems for investors. Potential future inflation could also cause a situation where both stocks and bonds decline at the same time, increasing the risk for investors. Today we will discuss: • Why the future returns of the 60/40 portfolio may be lower than they have been in the past; • How additional asset classes such as commodities, gold and real estate can work as complements to a stock and bond portfolio; • How unconventional asset allocation strategies such as the Permanent Portfolio, All Weather Portfolio, Protective Asset Allocation and Generalized Protective Momentum can offer broad protection against future uncertainty and be combined into one risk managed investment strategy. |
60/40 Has Delivered In Spades
The chart below shows just how good the 60/40 portfolio has performed over the past 30+ years. From 1987 to the end of early 2022, the 60/40 portfolio delivered an annualized return of 9.2% with acceptable levels of volatility and manageable drawdowns. Since the end of 2008, a simple stock/bond portfolio has delivered with the portfolio more than tripling from that time through the February 2022. But in 2022, the 60/40 is off to one of the worst starts due to a host of risk factors.
Source: Portfolio Visualizer, 60% US Stock Market, 40% Total Bond Market (Rebalanced Annually)
Elephants In the Room: Stock Valuations, Interest Rates & Inflation
There are three big challenges to the 60/40 portfolio in today’s market:
- Stock valuations are higher and as a result future returns for equities are likely to be lower.
- Interest rates are historically low and the expected returns on bonds are far below where they have been in the past.
- Higher inflation, which may result in higher rates, has the potential to hurt fixed income investors as bond holders realize losses on their holdings.
Charles Schwab put out a good chart that helps but the valuation picture in perspective. This is as of November last year, so some of the ratios have likely improved, but as we can see the market looks very expensive based on most standard valuation metrics.
Source: Source, “You’ve Got to Earn It: Earnings Growth Strong, But Descending”, Charles Schwab, Nov. 1, 2021
And when it comes to long-term interest rates, visualizing them can show you just how low yields are historically. The chart below shows the 10 Year Treasury Rate back to 1962. While yields are up significantly after hitting a low of 0.57% in August 2020, the current yield of 2.38% is far below the average yield of 5.09% over the last half century.
Source: https://www.macrotrends.net/2016/10-year-treasury-bond-rate-yield-chart
Inflation Highest In Decades
Now introduce inflation, which in February came through at 7.9% on an annualized basis, the highest since the late 1970s and early 1980s. The chart below, taken from the U.S. Bureau of Labor, shows the massive rise in inflation in the current environment. The Federal Reserve has now signaled interest rates are likely to increase to combat inflation. It’s impossible to know if inflation will be persistent or if these increases are transitory, but inflation is here now and increasing rates will have important effects across many key asset classes.
Source: https://www.bls.gov/charts/consumer-price-index/consumer-price-index-by-category-line-chart.htm
Prospect of Future Returns
Each month Vanguard puts out its estimates of 10 year annualized future returns on a series of asset classes. In the chart below, you will see I’ve highlighted the range of returns for U.S. Stocks and 10 Year Treasureys. On the high side, a 60/40 portfolio would produce an annualized 10 year return of 3.46% while on the low side returns for that portfolio would be 1.86%. No matter how you slice it, if the returns come in this range many investors are likely to be disappointed and they are far below the average return of the 60/40 I discussed earlier.
Source: https://advisors.vanguard.com/insights/article/marketperspectivesfebruary2022
Toss in the Towel – Nope!
So, does this mean we should just toss in the towel and give up on U.S. stocks and bonds?
We think the answer to that is: Absolutely Not!
However, we do think there are some important considerations for the long-term balanced investor. Let’s quickly work through each of these.
- Diversification;
- Alternative systematic strategies;
- Your return expectations;
- Your savings rate;
- Your withdrawal rates – i.e. the 4% rule.
- Importance of the Rebalancing Effect
Diversification
For investors holding U.S. stocks and bonds, diversifying into other asset classes may be an effective way to augment returns in the future. Asset classes such as commodities, gold, and real estate, particularly during inflationary times, can help prop up returns. In addition, value stocks and non-U.S. stocks have higher return expectations when compared to growth stocks and U.S. stocks in general. Getting more diversification now, particularly in some of those asset classes that have lagged over the last decade, could be ways to improve your returns.
Alternative Systematic Strategies
Diversifying into different asset classes can be good, but most investors don’t have a disciplined strategy in selecting what asset class to be in and when to be in it. This is where alterative systematic strategies can play a role. For example, we run strategies such as the Permanent Portfolio (stocks, short-term bonds, intermediate/long term bonds and gold) with and without trend-following and also alternative approaches like Generalized Protective Momentum and Protective Asset Allocation, which use momentum, correlation and have a crash protection stance to help reduce the possibility of a large drawdown in bear markets. For private clients we work with through our separate asset management firm, we combine all three of these approaches into one portfolio to in an effort to control for downside risk but still generate returns in asset classes when they are exhibiting strong momentum.
Lower Your Expectations
If you’ve gotten strong returns out of stocks (or stocks and bonds) it may be time to adjust your future expectations and realize, given what I’ve laid out, that the chances of the next 10 years being anything like the past 10 are low. Of course, we can never say anything with 100% certainty in the markets and the 60-40 has defied experts for a long time now, but the odds are low that it will deliver the returns over the next 7-10 years that it has over the last few decades.
Adjust Your Saving Rate
For those investors saving for retirement, one thing you can do if you’re able to is adjust your savings rate upward. If you believe future returns are going to be lower, saving more now allows you to build up your portfolio so that in the future when you do start making withdrawals, a higher withdrawal rate is possible. I understand not everyone has the ability to dial their savings rate up on a moment’s notice, but for those who can do it, and particularly those who are younger and have 20-30 years until retirement, saving more now can make a tremendous differerence due to the power of compounding.
Adjust Your Withdrawal Rate
For investors who are retired, or soon to retire, some may have the ability to lower their withdrawal rate. For instance, if an investor has $1.5 million and is withdrawing 4% a year, or $60,000 from the portfolio, perhaps there is the ability to lower the withdrawal rate to 3%, or $45,000. The image below is taken from a recent article in Barron’s and is based on Morningstar data – this shows that a portfolio with 50% stocks, 10% cash and 40% in bonds would be able to last 30 years under a withdrawal rate of 3.3% and last 40 years with a withdrawal rate of 2.8%.
Source: Barrons, “Forget the 4% Rule. Why Retirees Need to Rethink Their Withdrawal Strategy”, December 10, 2021
The Rebalancing Effect
Some investors rebalance their portfolio annually, while others may do it more frequently or based on some life event (i.e., nearing or entering retirement). But one way to potentially combat lower returns is to take a more opportunistic approach with rebalancing. This is a little tricky, and could add to the risk of a portfolio, but it’s worthy of consideration. For example, take early 2020 when the markets were reeling from COVID and the risks it presented to the global economy. A 60/40 would have seen stocks down about 35% at the low in March 2020 and bonds flat to slightly down during that period. An investor who would have rebalanced back to the target 60/40 allocation after stocks bottomed and started showing signs of stabilization would have improved their returns. So the goal is to rebalance back to the target weights after outsized moves up or down to try and take advantage of mean reversion in the markets. This might be a little too much to ask most investors but could be a strategy for some in what looks like a low return environment.
The Future of the 60-40
While the 60/40 has been a wonderful approach for the last three decades, the future returns may not be as good as in the past. Investors who are allocated to strategies like the 60/40 may need to think a little outside the box to enhance their returns going forward. Some of the options I suggested in this article could help with that.
Bonus Feature
Jack Forehand, my partner and co-host of Excess Returns, and I did a podcast last year on this topic, and some alternative systematic approaches we utilize. Those investors who find this topic important and are looking for ways to diversify their portfolios and mitigate some of the risk of the 60/40 from this point forward may find this discussion interesting.
Justin J. Carbonneau is VP at Validea & Partner at Validea Capital Management.
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