Daily Gains Letter

Is the 60/40 Rule of Investing Outdated?

By for Daily Gains Letter |

110313_DL_zulfiqarWhen it comes to asset allocation, most experts refer to the 60/40 rule as a starting point. This rule suggests that investors should allocate 60% of their portfolio to stocks, and the other 40% in bonds for balanced growth. The reasoning behind this ratio is that stocks, on average, tend to be volatile, so by combining them with bonds, investors can reduce portfolio fluctuations and wild swings.

With that said, this 60/40 strategy has served investors well over time. If you look at the performance of a portfolio that has implemented this rule, it has gained an average of 8.6% a year from 1926 to 2011. The worst year for the 60/40 portfolio was 1931, when it would have caused investors a loss of 26.6%; the best year was 1933, resulting in gains of 36.7%. (Source: The Vanguard Group, Inc. web site, last accessed March 7, 2013.) Over the 86-year period, only 10 years resulted in a loss for investors who followed this balanced portfolio strategy.

While this may be great, bond prices are near their all-time high, and interest rates have fallen significantly, hovering very close to zero—so, does this strategy make sense anymore? Keep in mind that the main idea behind this rule is to decrease portfolio volatility by buying bonds.

According to BlackRock, over the past 15 years, the correlation between the 60/40 portfolio and the stock market was 0.99. (Source: BlackRock, Inc. web site, last accessed March 7, 2013.)

This means that the 60/40 rule didn’t really decrease the volatility from the portfolio. The correlation suggests that if investors just kept their entire portfolio in stocks, their returns would be similar—assets were spread in different classes, but didn’t provide true diversification.

Looking ahead, this strategy seems to be becoming less relevant. Right now, the capital gains on bonds are severely limited. Look at 30-year U.S. bonds, for example. They are yielding 3.1% and trading near their highest price level in at least 30 years. The chart below depicts the precise picture.

dl_03112013_image002Chart courtesy of www.StockCharts.com

With all of the Federal Reserve’s money printing and an extended period of low interest rates, if the Fed goes ahead with raising interest rates, bond prices could suffer—the volatility will increase in the bond market. Thus, investors will bear more risk.

If your portfolio is allocated as per the 60/40 rule, it is time to pause and reflect, because it may cause more havoc than good.

Some may suggest investors get more exposure to the stock market, meaning allocating 70% of a portfolio to stocks instead of 60%. This may work for some, but for those who are trying to protect their savings, losses can add up significantly if there is a downturn. Not everyone is comfortable with high exposure to the stock market.

One way investors can reduce volatility in their portfolio is by holding cash or cash equivalents. According to the 60/40 rule, bonds are kept to reduce downside risk. Cash can serve the same purpose. Consider this scenario: with a portfolio that’s 60% stocks and 40% cash, if the stock market turns lower by 10%, your loss will only be six percent.

Holding cash and cash equivalents can certainly reduce upside potential, but it reduces risk, as well. When planning for retirement or saving for the long term, investors must evaluate their risk to ensure growth.

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