Introduction
I’ve always been curious about the 60/40 portfolio, yet have never structured my investments like this. The 60/40 portfolio is a popular investment strategy that has been used by many investors for decades. The portfolio consists of 60% stocks and 40% bonds, with the goal of achieving a balance between growth and stability. The strategy is considered a classic asset allocation model and is often recommended by financial advisors as a suitable investment strategy for individuals with a moderate risk tolerance. In this article, we will explore the pros and cons of the 60/40 portfolio and examine the basics and whether it is the right investment strategy for you to investigate further.
Pros of the 60/40 Portfolio
- Diversification: One of the primary advantages of the 60/40 portfolio is that it provides diversification across multiple asset classes. Stocks and bonds have different risk and return characteristics, which means that they do not move in tandem with each other. By holding both stocks and bonds, investors can reduce the overall risk of their portfolio while maintaining a level of expected return.
- Reduced Volatility: The 60/40 portfolio is designed to reduce volatility and provide more stable returns than a portfolio that is 100% invested in stocks. Bonds typically have lower volatility than stocks, and by including them in the portfolio, investors can reduce the overall volatility of the portfolio. This can help investors avoid the emotional rollercoaster that often comes with investing in a portfolio that is heavily weighted towards stocks.
- Income Generation: The bond portion of the 60/40 portfolio provides a steady stream of income through coupon payments. This income can help investors meet their financial needs, whether that is supplementing retirement income or funding other expenses. The income from bonds can also help investors stay invested during market downturns, as they do not have to rely solely on the appreciation of their stocks to meet their financial needs.
- Preservation of Capital: The bond portion of the 60/40 portfolio also helps to preserve capital. Bonds are generally considered less risky than stocks, and in times of market volatility, the bond portion of the portfolio can act as a buffer against losses in the stock portion. This can help investors avoid large losses and preserve their capital for future investment opportunities.
- Long-Term Growth Despite: its conservative nature, the 60/40 portfolio can still provide long-term growth potential. Over the long term, stocks have historically provided higher returns than bonds, and by including a significant allocation to stocks in the portfolio, investors can benefit from this long-term growth potential.
Cons of the 60/40 Portfolio
- Lower Expected Returns: The 60/40 portfolio is not designed to provide the highest possible returns. By including a significant allocation to bonds, investors are sacrificing some potential return in exchange for reduced risk. For investors with a higher risk tolerance, a portfolio with a higher allocation to stocks may provide higher expected returns.
- Interest Rate Risk Bonds: are sensitive to changes in interest rates, and when interest rates rise, bond prices fall. This can result in losses in the bond portion of the portfolio. While bonds can provide stability and income, they also come with the risk of interest rate fluctuations.
- Inflation Risk Inflation: can erode the purchasing power of bond income over time. While bonds provide a steady stream of income, the income may not keep up with inflation. This can result in a reduction in the real value of the portfolio over time.
- Limited Flexibility: The 60/40 portfolio is a relatively static allocation model, with a fixed allocation to stocks and bonds. This can limit the ability of investors to make changes to their portfolio in response to changing market conditions or individual needs.
- Increased Exposure: to Market Risk While the 60/40 portfolio is designed to reduce volatility and provide stability, it still exposes investors to market risk. While bonds are less volatile than stocks, they still carry a degree of risk, and the stock portion of the portfolio can experience significant volatility. During market downturns, investors in a 60/40 portfolio may experience losses, although these losses may be less severe than in a portfolio that is 100% invested in stocks.
- Low Distributions: Low natural distributions are a reality of the 60/40 portfolio. The natural income from distributions and coupons from the stocks and bonds of this portfolio are still relatively low when compared to a portfolio of dividend growth stocks. The need to eventually live easily off this portfolio is the end game and with low natural income, the 60/40 portfolio may not fit the requirement of the income investor.
How the 60/40 portfolio performed during the pandemic
The recent bond market crash during the COVID-19 pandemic has brought into question the effectiveness of the 60/40 portfolio during times of economic uncertainty. In March 2020, as the pandemic started to spread globally, the bond market experienced a sharp decline, causing a lot of concern among investors who had invested heavily in bonds as part of their 60/40 portfolio.
The decline in the bond market was caused by a sudden increase in interest rates, triggered by concerns over inflation and the long-term impact of the pandemic on the global economy. As interest rates rose, the prices of existing bonds declined, leading to significant losses for investors who held bonds as part of their investment portfolio. This uniquely coincided with a drop in equities. The reason investors of the 60/40 portfolio hold this mix of stocks and bonds is the perceived low correlation between stocks and bonds – recent events show that stocks and bonds can and do drop sharply together.
Despite the significant decline in the bond market, the 60/40 portfolio performed relatively well during this period. While the bond portion of the portfolio experienced losses, the stock portion of the portfolio eventually rallied and helped to offset those losses. Since the stock market did not experience as significant lengthy decline during this period the total returns of the 60/40 portfolio seem OK. The danger was the period when both stocks and bonds were significantly down at the same time.
For example, according to data from Vanguard, during the first quarter of 2020, the 60/40 portfolio (represented by a combination of the Vanguard Total Stock Market Index Fund and the Vanguard Total Bond Market Index Fund) declined by approximately 12%. While this may seem like a significant loss, it is worth noting that the S&P 500 index, which represents the overall stock market, declined by more than 20% during the same period.
This indicates that the 60/40 portfolio was able to provide some muted degree of protection to investors during the bond market crash, thanks to the diversification provided by its allocation to stocks and bonds. But to tell the truth, it wasn’t great, nor did bonds act in the way they were expected to during this unique event. Those that held gold instead of bonds fared much better.
However, it is important to note that the performance of the 60/40 portfolio during the recent bond market crash is not a guarantee of its future performance during similar market conditions. The economy is always changing, and the bond market could experience a different type of decline in the future that could impact the performance of the 60/40 portfolio differently. Bonds are only now beginning to revive 3 years on.
Therefore, investors should always evaluate their investment strategy and ensure that it aligns with their risk tolerance, investment goals, and time horizon, and should consult with an independent financial advisor before making any investment decisions.
Is the 60/40 Portfolio Right for You?
The better question is really “Is the 60/40 portfolio something I ow want to continue to explore?”.
Whether the 60/40 portfolio is the right investment strategy for you depends on a variety of factors, including your risk tolerance, income needs, investment goals, and time horizon. Key to understanding any portfolio is knowing how it might perform under many different scenarios.
Here are a few questions to consider when you are initially evaluating whether the 60/40 portfolio is right for you:
- What is your risk tolerance? The 60/40 portfolio is considered a moderate-risk investment strategy. If you have a low risk tolerance and are uncomfortable with market volatility, the 60/40 portfolio may be a suitable investment strategy for you. If you have a high risk tolerance and are comfortable with market volatility, you may want to consider a portfolio with a higher allocation to stocks.
- What are your investment goals? The 60/40 portfolio is designed to provide a balance between growth and stability. If your investment goals are focused on long-term growth with a moderate level of risk, the 60/40 portfolio may be suitable for you. If your investment goals are focused on high growth potential and you are willing to accept higher levels of risk, you may want to consider a portfolio with a higher allocation to stocks.
- What is your time horizon? The 60/40 portfolio is a long-term investment strategy that is designed to provide consistent returns over time. If you have a long time horizon and can afford to ride out short-term market volatility, the 60/40 portfolio may be a good fit for you. If you have a shorter time horizon and need to meet specific financial goals within a shorter period of time, you may want to consider a portfolio with a higher allocation to bonds.
- What are your income needs? The 60/40 portfolio does not produce high levels of natural income from coupons and dividends. To live off the 60/40 portfolio you would need to draw down regularly off the total return. You would need to model this and be sure it was fit for purpose. The drawdown period is often forgotten by investors who seem to only focus on the accumulation period.
In Summary
The 60/40 portfolio is a popular investment strategy that has been used by many investors for decades. The portfolio is designed to provide a balance between growth and stability by including a significant allocation to both stocks and bonds. While the 60/40 portfolio has many advantages, including diversification, reduced volatility, income generation, preservation of capital, and long-term growth potential, it also has some drawbacks, including lower expected returns, interest rate risk, inflation risk, limited flexibility, and increased exposure to unexpected market risk.
For all the reasons discussed above, I do not use the 60/40 portfolio methodology.
Instead, I’m looking for steadily growing stream of natural income from my investments.
Whether the 60/40 portfolio is the right investment strategy for you depends on a variety of factors, including your risk tolerance, investment goals, income needs and time horizon. If you have a moderate risk tolerance and are looking for a long-term investment strategy that provides a balance between growth and stability, the 60/40 portfolio may be a suitable investment strategy for you to investigate further. However, if you have a higher risk tolerance, a need for higher natural income or a shorter time horizon, you may want to consider a portfolio with a higher allocation to other types of investments. As always, it is important to do your own thorough research and conduct a modelling exercise to see what is fit for purpose. If you get confused or stuck always consult with a qualified independent financial professional.
Cheers
