The so-called “60/40 portfolio” has been around as a rule-of-thumb for decades. As the name implies, the 60/40 portfolio is typically comprised of 60% broadly diversified stocks and 40% in bonds. Exactly when and how 60/40 became such a financial industry staple is not entirely clear. However, the idea probably gained popularity with Harry Markowitz’s 1950’s work on “Modern Portfolio Theory” (MPT)”. From MPT developed the idea of an “efficient frontier” or the theory that there is some mix of assets that produces the maximum expected return per unit of risk. This evolved to mean a mix of broadly diversified stocks and bonds.
The 60/40 portfolio has routinely been pronounced “dead” over the last couple decades. This is partly because it makes for a good story with a catchy headline. We don’t think there is something inherently wrong with a portfolio of 60% stocks and 40% bonds. In other words, the 60/40 portfolio isn’t “dead.” However there are some real challenges. In this article we’ll discuss the real risks to consider if you are holding a static 60/40 (or similar) portfolio.
What are the risks of a 60/40 portfolio?
There are real challenges to how the 60/40 portfolio has classically been applied:
- A 60/40 portfolio may be vulnerable to high inflation.
- If bonds and stocks start moving more in tandem, it could increase the risk in a 60/40 portfolio.
- Even if 60/40 is the right overall risk level for you, it may not be the most tax-friendly allocation for all your portfolios.
- A 60/40 portfolio may not produce the right return or risk profile for your personal situation, either now or in the future.
How does inflation affect a 60/40 portfolio?
A larger bond allocation can reduce recession-related risks, but can increase inflation-related risks. Both of these risks are key considerations when determining an asset allocation.
Bonds are also often referred to as “fixed income.” That’s because the vast majority of bonds pay some fixed interest rate, set at the time the bond is first issued, which doesn’t change over the life of the bond.
Therein lies the reason inflation is so problematic for bonds. Say a bond is issued today with a 5% interest rate attached to it. Is that a good return? A lot depends on the rate of inflation in the future. If inflation were 2%, the investor would still be 3% ahead net of inflation: 5% stated return less 2% erosion in purchasing power.
But what if inflation is 5%? Then the investor just broke even after accounting for inflation. In finance we call that the “real” return - the investment return that is over and above the rate of inflation. In this case, the investor would have made 0% real return on 40% of their portfolio. That kind of result would ruin a lot of retirement plans.
Stocks don’t necessarily do well in years where inflation spikes either. More on that in the next section. However, over time stock prices tend to grow as company revenue and profits grow. If profits are partially growing because of inflation, that too tends to boosts stock prices. So in this sense, stocks are a kind of longer-term inflation hedge.
This isn’t to say that a 40% bond allocation is automatically too large for you. However, we do believe that larger bond allocations carry more inflation risk, and this is something to consider when setting your asset allocation.
Could stocks and bonds both decline at the same time?
The foundation of the 60/40 portfolio concept is that stocks and bonds have a low correlation. If that changes in the future, the 60/40 portfolio could become more risky.
As we said above, the idea of the 60/40 portfolio is built on the idea that stocks and bonds tend to move in opposite directions. Stocks tend to suffer larger declines when the economy is weak. When the economy is weak, bond prices tend to rise. That is partly because investors seek out the safety of government bonds. It is also because the Federal Reserve is usually cutting rates. Falling rates cause bond prices to rise.
When the economy is strong, it may be a time when the Fed is hiking rates, but historically, if the Fed has hiked relatively slowly, stocks have still performed well.
These dynamics are why, in the recent past, bonds and stocks have tended to move in opposite directions.
The table below shows every time that the S&P 500 fell at least 10% over the last 30 years. Here we used the Bloomberg Aggregate Bond Index for bonds.
| Stocks | Bonds | |
|---|---|---|
| 1/3/22-10/12/22 | -24.5 | -14.4 |
| 2/19/20 - 3/23/20 | -33.8 | -0.9 |
| 9/28/18 - 12/24/18 | -19.4 | 1.6 |
| 4/29/11 - 10/3/11 | -18.6 | 5.4 |
| 10/31/07 - 3/9/09 | -54.8 | 6.2 |
| 9/28/00 - 10/9/02 | -45.2 | 22.6 |
| 7/17/98 - 8/31/98 | -19.2 | 1.9 |
Source: S&P Dow Jones Indices, Bloomberg
Notice that bonds have usually produced positive returns during these periods except the last two instances. The 2022 period is worth considering. That year the Federal Reserve was hiking interest rates aggressively in order to quell inflation. Rapid rate hikes can damage the economy, which in turn creates risks for stocks. This is why both stocks and bonds suffered large declines in 2022.
For most of the last three decades, inflation has been low and fairly steady. When the economy was weak, the Fed cut rates, which boosted bonds. However, it could be that going forward, inflation is more volatile. If that is true, it could become more common that the Fed has to hike aggressively. That might cause bonds and stocks to move in the same direction more often, also known as a higher correlation.
If this is true, then bonds might not be as good at diversifying portfolios as they once were. We believe it is still very likely that bonds will be much more stable than stocks. But investors might want to consider adding certain alternatives, such as Facet’s Alternative Income strategy, that could provide some protection against rising interest rates.
None of this is to say that 60/40 is an inherently bad asset allocation. Rather it is to say that it could be that the risk characteristics of the classic 60/40 portfolio are shifting. That may mean reconsidering if that allocation is right for you.
Should I allocate all of my accounts with the same mix of assets?
There may be important tax reasons to have a different asset allocation for different types of accounts.
Regardless of what overall asset allocation you select, you may want to consider having a different allocation for each of your accounts. It is certainly true that if you have different accounts with different purposes, that probably necessitates a different asset allocation. Saving money to buy a home in two years is a very different risk profile as saving for retirement 20 years from now.
However, there are also tax reasons to consider having a different asset allocation for each account, even if all accounts are part of your retirement planning. Any money that is taken out of a traditional IRA is taxed as ordinary income. When you reach 73, you must start taking required minimum distributions or RMDs - which is a legally required amount you must withdraw (and therefore pay tax) from your IRA. This is calculated as a percentage of your IRA balance.
Say you have a taxable account and an IRA and they are both $500,000 today. Say you invest in a 60/40 portfolio that makes 7% per year. At the end of 10 years you will have approximately $984,000 in each account. If you are due to take RMDs from the IRA that year, you will have to take about $37,000 in distributions, and will owe tax on that amount.
Alternatively, say you invest your taxable account in a more stock-heavy allocation that makes 10% per year, and your IRA in a more bond heavy allocation that makes 3% per year. That winds up being the same overall return for your combined accounts. However, in this scenario you have about $1.3 million in your taxable account and $670,000 in your IRA. In that scenario, your RMD will only be about $25,000.
By lowering your RMD, you could save thousands on taxes every year, while still having the same overall nest egg in retirement.
This concept is called asset location, which is the strategy of placing different types of investments into different types of accounts (like taxable vs. tax-advantaged) to maximize tax efficiency. This can get a little complicated, especially if you have more than just two account types. Exactly how to best utilize this strategy depends greatly on your own situation. Suffice to say, you shouldn’t blindly set your asset allocation at 60/40 (or any other allocation) in all of your accounts.
Is a 60/40 portfolio right for me?
Determining your asset allocation is arguably the most important decision an investor will make. You want to select the allocation that has the right risk and return profile for your individual situation, not just use a simplistic rule-of-thumb solution.
Your asset allocation decision should be personalized to you. In our opinion, simplistic solutions like the 60/40 portfolio or a target date fund, fall short of capturing the nuance of your situation. Even two people who are the same age and plan to retire at the same time could need substantially different asset allocations depending on a variety of factors:
- Spending plans: What percentage of your retirement nest egg do you plan to spend each year?
- Legacy goals: Do you have a spouse or children who will inherit your assets? How important is growing your money to leave for the next generation?
- Outside income: Will there be pension income? What about working part time or consulting?
- Large purchases: Do you plan on buying a second home? Moving abroad?
- Other assets: Do you expect an inheritance? Cashing out company stock? What about downsizing to a smaller house? Will those assets be added to your retirement?
- Retirement date certainty: Is your retirement date set in stone? Or do you want flexibility to retire earlier or later?
Each of these factors (as well as many others) may influence your asset allocation decision. This is why we think having a comprehensive retirement plan is so important. It is likely that there are factors you haven’t considered that may not be reflected in your current investment plan.
It could be that after doing all of this analysis and planning, it turns out a 60/40 portfolio is indeed right for you. But that would be something of a coincidence. We prefer to start with your plan and then let that guide your asset allocation decision, as opposed to starting with an investment program and seeing if it fits you.
Disclosure
This article is intended to be an analysis of current market news only. It is not intended to be advice, a recommendation or any type of forward guidance. Facet Alternative Income Strategy is exclusively available to Facet Plus & Complete members who are Accredited Investors. Investing carries inherent risks including the loss of principal and past performance is no guarantee of future results.
