Many financial advisors have recommended the time-tested 60/40 portfolio to investors for decades.
The 60/40 portfolio, which calls for 60% of a portfolio to be invested in stocks and 40% in bonds, has outperformed other “balanced” portfolio approaches.
But it’s had a lot of help — help that likely won’t be here for the next 20 or 40 years.
The premise of the 60/40 portfolio is that it provides exposure to higher-returning stocks, while also offering exposure to lower-risk fixed-income investments.
It’s been heavily recommended, and for good reason; it has been a fruitful strategy for the last half-century. This approach had positive returns 80% of the time over a one-year rolling period.
The 60/40 portfolio only fell more than 20% in a year one time while posting 20% or more annual returns roughly 10 times.
The big issue is that the only two components of the 60/40 portfolio — stocks and bonds — will likely underperform going forward.
Both are already at historically high valuations and neither appear to have catalysts that will help it match the returns over the last half-century.
So-called 60/40 investing can be a relatively easy strategy and a set-it-and-forget-it option. It offers reduced volatility. The 40% exposure to fixed-income and is meant to not be too risky but not overly safe — providing retirees with enough return to keep pace with rising costs of living.
Take the Vanguard Balanced Index Fund (VBIAX), which invests using the 60/40 rule. The fund invests in 60% stocks, such as Apple (AAPL) and Microsoft (MSFT), with the other 40% invested in government bonds and U.S. Treasuries.
The VBIAX fund has an annualized return of 6.42% since its inception in November 2000.
For 2020, which includes the coronavirus fallout, the VBIAX has marginally outperformed the S&P 500. Still, over the course of the least 20 years, the VBIAX and S&P 500 has performed relatively the same on a total return basis.
For 60/40 portfolio advocates, the math now works against you. Where do the future stock returns come from with valuations already so high?
Fiscal stimulus helped push stocks higher and avoid a more severe fallout from the coronavirus pandemic.
This could just be delaying the inevitable, says famed investor Stanley Druckenmiller, who believes the Federal Reserve’s recent actions have created a huge party in the stock market that will lead to outsized inflation.
Stock valuations are already high, with the S&P 500 price-to-earnings (P/E) ratio at 28 times. Nobody should expect to get double-digit returns going forward from U.S. large-cap stocks.
The low yield on bonds won’t do much to offset the low returns of stocks, and any surge in inflation will quickly eat away the small yield provided by bonds.
It’ll be a “lost decade” for stocks, especially as the lingering effects of the pandemic are felt, says Blackstone vice-chairman Tony James.
In particular, average annual returns for U.S. stocks over the next 10 years should come in between 4% and 6%, suggests Goldman Sachs and Vanguard.
On the fixed-income side, the 40-year period of falling interest rates has propped up the 60/40 portfolio. But for the 40 years prior to 1980, the 60/40 portfolio handily underperformed the market thanks to outsized returns for bonds.
During the years the 60/40 outperformed, the 10-year Treasury posted an annualized return of 7.4% from 1980 to 2019.
The 10-year Treasury yield stands at less than 1% today. At the start of 1980, it was almost 11%, while the average 10-year yield during that period was just over 6%.
From 1940 to 1979, when the 60/40 portfolio underperformed, bonds returned an annualized 2.8%. Fixed income had a great run that propped up the 60/40, but it’s a run that looks impossible to replicate as interest rates currently sit around 0%.
Bonds will likely return just 2% to 3% a year going forward.
The New 60/40 Strategy
The next 40 years will look nothing like the last 40 when it comes to stocks and bonds. The key drivers of the 60/40 portfolio are fundamentally broken.
Granted, it still provides immense convenience, investors should look to alternatives for greater opportunities. Diversification between stocks and bonds will be less important going forward. Instead, diversification among asset classes will prove most effective.
Investors looking to replace low-yield bonds may have luck looking toward real estate. Some stock allocation may be best put toward commodities or private equity.
For investors partial to stocks, look to value stocks instead of growth, and consider foreign and emerging markets. High-quality, high-dividend paying stocks can be alternatives to bonds.