THE TRADITIONAL 60/40 portfolio allocation strategy has been
a long-standing investment approach that has worked for many investors,
bringing in reliable gains for years. That said, 2020 has brought about a new
market scenario that may challenge this strategy from meeting its standards.
This investment strategy, in which 60% of the portfolio is
allocated toward stocks and 40% toward bonds, has been a default way to
construct an investment portfolio for many long-term investors.
Investors who adopt this strategy have a majority allocation
toward price-sensitive stocks, which tend to be more volatile during market
swings but help drive portfolio returns. The other segment is devoted to bonds,
typically government bonds, which are often thought of as a stable financial
security.
This mainstream investment strategy has gained popularity
among long-term investors because the mix of assets and their allocation offer
balance and diversification for investment gains in either a bullish or bearish
market. According to Vanguard's calculations based on data from Morningstar,
the 60/40 investing strategy with two asset classes, stocks and bonds, between
1926 and 2019, had an annualized return of 8.8%. To achieve this calculation,
Vanguard used several different stock and bond indexes as benchmarks of
performance within this time frame to find the average annual return of the
60/40 portfolio allocation.
With the many changes this year has brought, most notably the
Federal Reserve's decision to drop interest rates to stimulate the economy amid
the health crisis, and the overvaluation of equities, investors are worried
their investments will have trouble covering their retirement needs and are
skeptical whether this strategy can be relied upon. Consider the points below:
- The 60/40 dilemma.
- Changing portfolio construction.
- Looking at other assets.
The 60/40 Dilemma
The pandemic has had global ramifications, impacting all
areas of the economy differently.
While many sectors have been suffering, we saw the rapid
rise of the tech sector in recent months driving high equity valuations in tech
stocks. S&P 500 yearly returns are up 14.45%, driven by the index's sizable
weighting of 27.4% in the information technology sector.
While a surge in stocks may come as a positive, it can also
pose portfolio risks and compel retail investors to seek other safer methods to
invest in – from high-flying stocks to lower-risk securities.
Another risk comes from bonds. Currently, the 10-year
Treasury yields slightly more than 0.87% and the two-year yields 0.16%, which
may be unsustainable investments for fixed-income investors.
Aaron Sherman, president at Odyssey Group Wealth Advisors in
Lancaster, Pennsylvania says a 60/40 investor with a long-term time horizon may
be sacrificing growth in a portfolio that's more conservative than their
situation demands.
"With interest rates so low, bonds now contribute very
little (if anything) to overall investment return, so a 60/40 investor must
accept a lower return for the same amount of risk," Sherman explains.
Bonds are not serving their purpose, which is to provide
income for retirees and hedge against inflation. With economic productivity
likely to remain low, it will be difficult for bonds to reach their full
potential in this low-yield market environment. This could lead investors to
seek other strategies and/or financial instruments to compensate for
poor-performing bonds.
Looking ahead, investment returns may be more modest than
they were in the past, which has investors thinking: "Will I need to
adjust or change their investment strategy altogether, or take on additional
risk to have the chance of receiving higher returns?"
Changing Portfolio Construction
There's more to a 60/40 portfolio than just stocks and
bonds.
Diversification of assets should be considered as this
strategy helps manage portfolio risk and hedges against volatility.
Diversifying assets is an important investment strategy, but maybe that can be
done by incorporating other assets apart from the traditional approach.
This brings into question what types of assets, how they are
to be allocated and whether investors need to adjust their risk tolerance.
Stocks and bonds are held in a portfolio because they either
help drive returns or serve as an offset to risk from the volatility that may
arise. Experts say the 60/40 allocation may not need to change, rather the
financial securities might require some adjustment or replacement, particularly
on the bond side, given the negative impact of bond performance due to lower
interest rates.
"If bonds cannot continue to rally or go up in price as
(they have) in the last 40 years because interest rates are now near zero, then
you have a different profile in terms of diversification," says Neil
Azous, founder and chief investment officer at Rareview Capital in Stamford,
Connecticut.
Azous says, "Based on what the pandemic has led to,
there's a wholesale change to portfolio construction." As a result, Azous
and others have been implementing other portfolio allocation strategies to
compensate for a portfolio's underperformance.
He highlights that the 40% part of the 60/40 portfolio,
which is traditionally made up of nominal bonds, is being replaced with an
inflation protection mix of assets, like inflation-linked bonds, commodities or
break-even inflation instruments.
These assets, Azous explains, will hedge against inflation
in the event of another economic decline. "The function by the government
to protect against a market downturn is going to print more money and that is
going to be an inflationary event," he says. "To hedge against that,
you need to replace the nominal portfolio of 40% with inflation-linked
products."
Looking at Other Assets
It may be challenging for some investors to adjust their
asset allocation; therefore, they may turn to different financial securities.
Tara Fung, chief revenue officer at AltoIRA in Nashville
says retail investors are increasingly interested in holding assets outside of
public stocks, bonds and mutual funds and want more diversification and access
to high-returning, long-term alternative investments to make up for savings
shortfalls.
"They are allocating more of their portfolios toward
private market opportunities. Instead of dividing retirement savings into just
stocks and bonds, investors are now using their (individual retirement
accounts) to invest in startups, securitized art, private real estate and
crypto," Fung says.
Alternatives assets can offer diversification in your
portfolio, hedge against market risks and help build portfolio gains. For
example, preferred stocks could offer income through dividend payments and help
with increasing portfolio returns. Adding exposure to commodities such as
agriculture, oil, natural gas or precious metals like gold and silver could be
another option for their low correlation with equities.
Individual investors may look to other assets like real
estate investment trusts, or REITs, known to increase dividends, which can help
with increasing yield for those in retirement. The cryptocurrency market has
also been expanding as more investors are growing comfortable with the idea of
owning these volatile assets.
These securities could work as alternatives, but investors
need to know what their risk tolerance is before adding alternative investments
to their portfolios.
James Demmert, founder and managing partner at Main Street
Research in Sausalito, California, points to specific assets that could serve
as "bond alternatives." For example, he notes securities such as
individual bonds of varying credit quality, like AAA to BB – as rated by rating
agencies Standard & Poor's and Fitch Ratings, who use these ratings to
classify the credit quality of an asset. He also says individual preferred
shares of very high-quality companies and yields between 3.5% and 4.5%,
individual REITs with strong balance sheets and yields between 3% and 5%, and
individual utility stocks with strong balance sheets and yields of 3% to 5% do
not pose as many risks as stocks but can deliver yields similar to the
traditional bond market.
"This diversified group of securities has allowed us to
capture what we used to be able to achieve with an all bond portfolio. It is
important that our clients are aware that these securities pose more risk than
bonds but much less than stocks," Demmert says.
The Takeaway
The performance of the 60/40 portfolio strategy has been
sustainable based on its historical performance, but experts urge investors to
look at what assets are in your portfolio and how they are positioned.
To secure your investments in this sensitive economic
environment and prepare for future risks, find financial securities that can
weather volatility and that fit your risk appetite to create a sustainable
balance between your risk and returns.
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