“The Future Ain’t What It Used To Be”….Rethinking The Traditional 60/40 Portfolio
Written by Firethorn Wealth Partners
October 1, 2020
Diversification has always been lauded as the ideal way to manage risk in an investment portfolio. The 2020 COVID experience has been both a reminder and a wakeup call about the merits of diversification during an extremely volatile year. We want to use this monthly letter as an opportunity to take a closer look at the 60/40 portfolio. The 60/40 portfolio is often considered the rule of thumb when it comes to a balanced portfolio. The portfolio name is derived from the 60% weighting in equites while the remaining 40% is allocated to bonds. Over the past forty years, the 60/40 portfolio has performed extremely well by returning 10.4% annually from 1980 to 2019. Both sides of the portfolio have been propelled by the decline in interest rates from historic highs in 1983 to historic lows (today).
We believe the expression “You can’t live life in the rearview mirror” is appropriate here as we think the past may not be a good guide to the future in respect to the 40% side of the portfolio. It is beneficial to outline the historically significant contributions of Fixed Income (bonds) in a balanced portfolio. In the past, core fixed income (which are treasuries and high-quality corporate debt) has provided current income, diversification, and a “hedge” to equity volatility, thus creating a smoother investing experience for investors along the way. We do not know what the future will hold, but returns will be harder to come by in traditional stock and bond models. According to JP Morgan, a 60/40 portfolio is projected to return 3.5% annually over the next decade, which would fall short of the return needed by many individuals to achieve their financial goals. After taxes, this rate of return might not even manage to beat the rate of inflation.
Investors have been starved for income in a declining interest rate environment. Many investors have been forced to change their allocation on the “40” side of their portfolio because of the lack of current income it provides. The alternative has been to invest in higher dividend paying stocks and other equity like securities, which by default has propelled stock prices higher. This creates a dynamic that forces investors to take on more equity risk that may be outside their comfort zone in an effort to maintain the same rate of past returns. We also think many of these same investors may not be aware of the increased risk exposure in their portfolio. Forty years of declining interest rates have caused an above average return for bonds due to the inverse relationship between rates and bond prices (as rates drop, the price of the bond goes up). There is little room for interest rates to decline further, but a lot of room for them to run higher. This has created an atmosphere making bonds more sensitive to interest rate moves than ever before. Current core fixed income portfolios do not possess the same ability to hedge stock market risk versus bond portfolios of the last forty years after the historic broad decline in interest rates. Fixed income will be faced with more challenges when inflation starts to show its ugly head. The overall theme of this memo is to explain what the new “40” should look like and why part of the title of look like and why part of the title of this newsletter is from the great Yogi Berra, “The Future Ain’t What It Used to Be.”
Looking ahead at the hood ornament of the car that is the next decade, investors should consider carving out some of their traditional fixed income allocation to include “non- traditional” fixed income instruments. In simple terms, investors need to further diversify theâœ40â sideoftheirportfolio into non-traditional fixed income or into other alternative solutions. A few examples of these are below:
- High Yield Corporate Bonds
- Preferred Stock
- Private Credit
- TIPS (Treasury Inflation- Protected Securities)
- Convertible Securities
- Real Estate
The overall message is that core bonds may no longer serve the dual purpose of satisfactory income and hedging going forward, but they are still an integral part of portfolio construction. Investors may need to incorporate the use of additional “alternative” sources of return to compliment or accompany core bonds in order to accomplish their financial goals.
As always, we are here should any of the articles spark questions or comments.