“The most important key to successful investing can be summed up in just two words: asset allocation.” – Michael LeBoeuf
Let’s discuss the 60/40 Portfolio Allocation, something you most likely will be familiar with. 60/40 allocation is the universal rule of thumb for investors, but why is it doomed?
As LeBoeuf says, asset allocation is the most important part of investing. For the majority, that means using the 60/40 portfolio allocation – 60% of assets in stocks and 40% in bonds. It’s the industry standard. Or at least, it was.
The investment industry has seen a trend of industry players arguing that the 60/40 allocation rule is doomed. It started in 2019 when the Bank of America released a research paper titled ‘The End of 60/40.’ And has since picked up interest from the likes of Morgan Stanley and JP Morgan.
So, what does the end of the 60/40 allocation mean?
Without the 60/40 allocation rule, the vast majority of investors, would need to start looking for a brand-new portfolio arrangement. Regardless of their networth.
Everyone uses the 60/40 allocation rule simply because:
- It has historically delivered great returns.
- It’s easy for casual and inexperienced investors to implement.
- It makes investors feel safe.
The idea is that this allocation will capture the long-term gains achieved by equities. While depending on the safe fixed income assets (like government bonds) to rally during short-term downturns in the stock market. The bonds hedge against risk to growth and the equities hedge against inflation. This works currently as the results are negatively correlated. But this correlation may soon flip which is also one of the reasons the allocation may no longer work.
Here you get the best of both worlds. The 60% higher risk of equities and 40% lesser risk of bonds should provide equity like returns. While smoothing out extreme highs and lows that come with 100% equities.You have a diversified portfolio, with steady income and appreciation.
What is rebalancing?
To make the 60/40 allocation work, investors must ‘rebalance’. Investors tweak their portfolio at least once a year to ensure the 60/40 split remains precise. If investors don’t rebalance their portfolio, they could potentially expose themselves to more risk than they are comfortable with.
Regular rebalancing prevents investors from making classic mistakes such as panic buying and euphoric selling. It teaches you to be disciplined with your investing. It also helps investors feel at ease in scenarios like highly volatile markets according to Claire Walsh, a personal finance director at Schroders.
Why is this relevant for you?
Ending the 60/40 allocation is far more significant than you may have initially thought. Currently no one has openly come out with a strategy to replace the 60/40 allocation entirely. There are a few alternative investment options that banks and advisors are encouraging investors to turn their attention to – something we will discuss further down. The reality is that the future is unclear.
The reason this is so important is because if your returns are going to significantly decrease, this may be a bigger cut than you thought. Wealth managers do not work for free and they take a fee for their service. It’s a fee that is not based on your returns but comes as a set cut out of your returns. If your returns are already meagre then what you actually end up getting will be even smaller.
Perhaps this information has opened your eyes to the on-going issue. If so, we hope you can feel more prepared and informed to have that conversation with your adviser.
Is the 60/40 portfolio allocation doomed?
JP Morgan has just predicted that the traditional 60/40 portfolio will only deliver an annual return of 3.5% over the next decade, compared to the 10% over the previous 4-5 decades.
The problem with bonds
In a nutshell, the 40% bonds which we know act as a hedge, are simply not producing the same returns they used to. In fact, the actual numbers show that roughly 25% of government bonds globally are yielding negative returns and the 10 year US treasury yields have fallen from 9.5% in 1989 to 2.8% in 2018. This is mostly due to the current investment environment as interest rates have collapsed, issues with real GDP growth in established markets and central bank monetary policy – all of which have kept bond yields artificially low.
Low bond yields leave less room for bonds to appreciate in an economic crisis. This makes them a lot riskier than they used to be and many are questioning their ability to act as ballast to stocks in a portfolio.
Jan Loeys, strategist at JP Morgan says, “in this zero-yield world, bonds offer neither much return nor protection against equity falls.”
Therefore, bonds may not be very attractive investments in this environment.
Moreover, the negative correlation between bonds and equity markets could flip – which would render the diversification of a 60/40 portfolio useless. A positive correlation between stocks and bond prices would mean both move in tandem with each other. Ultimately, this would be extremely risky.
If you’re simply looking to improve your returns, then buying more stocks is a no brainer. However, prepare to take the added risk that comes with a higher equities allocation.
Aside from returns, without the fall back on bonds, we also need to consider how to rebuild robustness into our portfolios.
They have suggested considering private equity investments. Particularly ones in core real estate funds that own commercial and residential real estate properties. Here, around 75% of your returns would come from rental income rather than asset appreciation. Which would make this investment more similar to bonds. The only drawbacks here is these investments are far less liquid and typically require high minimum investments.
Suggested investors slightly turn away from government bonds and safe assets to ‘hybrid assets’. These could be either loan obligations or real estate investment trusts and commercial mortgage back securities. Ideally, they would picture a portfolio along the lines of 20% in bonds, 40% in hybrid alternatives and 40% in stocks.
Believe that liquid alternatives may also be highly popular, with something like a merger arbitrage. A merger arbitrage means you’re still invested in equities. But the risk you're underwriting is the odds of the deal blowing up. Typically, transactions close or break within 12 months leading to shorter duration profiles meaning they’re still quite liquid.
Ultimately, the future of asset allocation may look radically different to what we all know and love. That's if the 60/40 portfolio allocation really is doomed. We have listed just three of the many potential alternatives available to you. What is important, is that you take the time to consider and research all these options. Maybe the solution is to look outside of the traditional US stocks and bonds market and turn to the global economy.
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By Catherine Child