Why the Traditional 60/40 Stock / Bond Portfolio is Broken

For almost 1/2 a century, the two asset class 60/40 stock/bond portfolio did an excellent job of providing growth, inflation protection, income and reducing risk. The two asset classes were complimentary to each other for much of this time. 

This mix might be 70/30, or it might be 50/50, all dependent on an investor’s risk profile. However, there is a major problem with this model.

The main draw to this strategy is in its simplicity. Most advisors believe that diversification of stocks and bonds is key to reducing portfolio risk and volatility. This view of diversification has seen some changes.

The investing environment now has low yielding bonds offering a negative real rate of return after adjusting for inflation. Bonds are at risk of dropping in value as interest rates rise.  While we have seen a significant correction recently in the stock market after bottoming out in March, stocks are again close to all-time highs after recovering and are at risk to a further correction as a result of the COVID-19 Pandemic economic shutdown. 

This historical combination of stocks and bonds offered protection in the past because bond values went up as the stocks went down, protecting the portfolio in a stock market downturn.

Bonds offered this protection since the peak of the interest rate cycle in 1980. There was very little risk of bonds losing money since bond values increased as interest rates dropped.  The reverse will now happen as interest rates start to rise and bond values fall, making bonds riskier than stocks going forward.

As a result, bonds no longer offer the protection to offset stock losses they once did.

Source: FactSet. Data as of 12/31/17[1]

Warren Buffet said it best; fixed income long term is the riskiest Asset Class that you can own today because after inflation, currency and interest rate risk, you will guarantee yourself a loss long term.

You need fixed income in your portfolio for income-generating needs, and especially for retirees, you need it for protection against downside risk. You also need it for when the stock market falls so that you can sell off those bonds to buy reasonably priced to lower than average priced equities that you want to own.

Source: GMO, Mauldin: The 60/40 Portfolio Is Riskier Than Ever  [2] 

In the past, bonds were included in a typical stock/bond portfolio as an inflation hedge and to reduce portfolio risk while contributing stable positive returns. Today the outlook for bonds going forward is flat to negative as the chart above shows. To offset this, Private Real Estate is recommended as a bond substitute.

Private Real Estate is a proxy for bonds and acts as an inflation hedge while offering a significant positive outlook over bonds. Bonds are still included in a portfolio to provide liquidity to fund retirement cashflow and to take advantage of stock buying opportunities when they arise. Shorter duration bonds are recommended to reduce the potential for losses.

Commercial real estate catering to government and private healthcare tenants and select newly renovated and purposely built apartment buildings in city centers catering to millennial tenants in non-rent controlled lower-priced markets can offer attractive investment returns.

Stocks have benefited from declining interest rates as well.  As interest rates declined, companies became more profitable as the cost of borrowing declined, meaning more of their profits could be used to grow the company.  Now that interest rates are at historical lows and are will eventually rise, corporate profits will be squeezed.  This means less profit for companies to reinvest back into their businesses and less opportunity to grow.

Stocks will continue to be an essential part of a portfolio. Traditionally investment advisors and mutual fund managers tend to purchase a basket of stocks that mirror a given market index. They do this to save on research and trading costs, and to avoid being wrong. Investment advisors and mutual fund managers do not want to underperform the market, so by selecting a basket of stocks that mirror the market; they ensure their portfolio returns are always close to the market returns less their management fees, typically 2%.

Given that stocks do poorly in a rising interest rate environment, investment advisors and mutual fund managers must be proactive in their stock selection going forward. While stocks will do poorly as the chart above suggests, active portfolio managers that proactively select stocks will do well. Even in a poor stock market environment, there will always be stocks that will do exceptionally well. For example, during this COVID-19 pandemic, certain technology and pharmaceutical stocks are doing exceptionally well.

To offset the volatility inherent in a publicly-traded stock portfolio and to improve the overall returns, Private Equity is recommended. No matter how good a publicly-traded stock is, it is susceptible to go down during a market correction, which can be unnerving for an investor. 

Private Equity is not publicly traded and, therefore, not susceptible to market influence. The value of Private Equity is determined by the profitability of the company, not the whims of the stock market. By adding Private Equity to a portfolio, portfolio managers reduce portfolio volatility.

By investing in private companies that benefit from an ageing boomer population such as nursing homes, healthcare, pharmacies, biotechnology companies, portfolio managers can generate attractive returns over public stocks with less volatility.

For most investors with an investment portfolio of less than $1,000,000, a minimum allocation of Alternative Assets of 10%-15% is recommended. For investors with more than $1,000,000 in their portfolios, a higher allocation of Alternative Assets can be added, this is determined by their risk tolerance identified through a discussion with a Discretionary Portfolio Manager that holds Chartered Financial Analyst (CFA) designation.

I also outlined in my book,  why you should be working with a Portfolio Manager who has the discretionary authority to act proactively to protect your portfolio from the impact of a market correction.

As with any market correction, the best strategy is not to panic during a market correction because the market will eventually recover.

To recover losses incurred during a market correction, you need to be in the market to participate in the recovery. That is hard to do when your portfolio has gone through a significant correction.

To mitigate the temptation to cash out of the market, you need to have a portfolio that is insulated from market volatility without reducing overall long-term portfolio returns.

So how do you find a Portfolio Manager that has the expertise to invest in Alternative Asset Classes and has the discretionary authority to protect your portfolio proactively?

Good question!

I cover this extensively in my book Who’s Investing Your Money? – 7 Key Questions to Ask Your Financial Advisor. This book examines the various types of advisor registrations, their limits and abilities and will help you find the right advisor for you.

To learn more about how Alternative Assets can help your portfolio recover from the recent market correction, please  call me at (604) 855-6846 or email me at aspitters@pfcwealthsolutions.com

Who’s investing your Money? is available as a free PDF download at www.whosinvestingyourmoney.com

Alternatively, the book is available from Amazon.ca as a paperback and Kindle version from this link: Who’s Investing Your Money? – Amazon

[1] “New Client Assets in Today’s Market: A Blessing or a Curse?” Paritas Capital Management, 6 Apr. 2018, https://www.paritascapital.com/blog/new-client-assets-in-todays-market-a-blessing-or-a-curse/.

[2] “GMO 7-Year Asset Class Forecast: August 2019.” Home, https://www.gmo.com/americas/research-library/gmo-7-year-asset-class-forecast-1q-2020/.

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