Traditional investing advice has been through a revolution in the last decade. A lot of deeply held beliefs that were challenged by the best — and the worst — stock market returns in a concentrated period of time. For years, average investors were told that the ideal portfolio was one that carried 60% of its total value in stocks, with the other 40% in fixed income securities like bonds. This mix was recommended as a way to gain exposure to the stock market while also granting the security and stability of interest income. Seems like a good idea, right?
Why a 60/40 portfolio is insufficient for today’s investors
Historically, there’s ample evidence to support the point of view that this strategy worked well for investors. According to Vanguard, a portfolio of 60% stocks and 40% bonds would have returned 8.6% annualized from 1926 through 2011.
Unfortunately, it looks like the 60/40 split may not hold up to our current market conditions. Today, Vanguard’s Total Bond Market Index Fund yields about 2.13% before fees. With the Fed’s commitment to keep interest rates low as the economy rebuilds after the COVID-19 pandemic, it is simply impossible for investors today to get the same returns from bonds.
Inflation averages around 1.7% a year, potentially getting you a whopping 0.43% return on the Vanguard fund mentioned above. Inflation is a major risk to the conventional 60/40 portfolio. While stocks do suffer from the impact of inflation, they also benefit as their earnings also grow in nominal terms. Additionally, the stock market seems to ‘build in’ the impact of inflation into its expectations. Bonds, on the other hand, provide a lower rate of real return and do not protect the real value of your portfolio.
Alternatives to the 60/40 portfolio
Since a 40% allocation to bonds is no longer expected to provide 2-3% stable returns, modern investors need to make some adjustments to their portfolio. However, simply more risk in the form of 100% equity investments is not prudent either. While it is true that most of us will need to save more money for retirement than our parents did, or work even longer, the solution is not to go all in on the stock market.
Experts say that the 60/40 allocation is not a bad idea, but what matters is the kind of assets that can be substituted in for bonds. Average investors have more options now than they did twenty or ten years ago – they can invest in startups, private or public real estate, art, cryptocurrencies, small businesses, and more.
For younger investors, it may be advisable to take on riskier allocations, such as 80/20 or even 90/10. As they progress in age and build their financial portfolio, their asset allocation should change along with them.
Alternative assets add diversification to your portfolio, which was the original intention of having a percentage allocation to bonds in the traditional 60/40 portfolio. These assets also hedge against market risks and help build long term gains. For example, adding exposure to commodities such as agriculture, oil, natural gas or precious metals like gold and silver could be an option for an investor looking for alternative assets. If they’re more interested in real estate but don’t have the time or down payment for multiple properties, investments in publicly traded REITs or non-traded crowdfunding platforms could be more appropriate. Additionally, a small percentage of the portfolio could be allocated to companies that have offered consistent dividends for decades to mimic interest income.
There is no denying that the 60/40 portfolio yielded above average returns for many years and was instrumental in helping the previous generation reach financial stability. It does, however, have limitations that have come into light due to the growing turbulence in financial markets. Additionally, the monetary policy adopted by the government is likely to keep interest rates low in the near future. A growing number of financial advisors and experts now recommend a diversified portfolio across different assets like stocks, bonds, cash, real estate, commodities, and more to achieve long-term growth with the investor’s accepted level of risk.