Kate Stalter, Contributor
March 15, 2021
A stalwart of retirement investing has been the 60/40 portfolio , consisting of 60% equities and 40% bonds.
The idea behind the 60/40 portfolio is to provide growth through stocks, but dampen volatility on the fixed income side. Historically, that means using short-term bonds with high credit quality, which historically have mitigated the risk of stocks.
Bonds also traditionally served a role to generate income.
The 60/40 rule lost some credence during the dot-com boom in the late 1990s, as stocks raced higher, and investors quite reasonably asked themselves: What was the point of owning bonds, which would drag down performance?
These days, financial advisors generally put clients’ assets in portfolios allocated to meet risk tolerance, time horizons and financial goals. That means using ETFs or mutual funds to diversify and smooth returns.
After a client takes a risk assessment quiz, his or or her portfolio is invested in a typical equity-to-fixed income model, such as 60/40, 50/50 or 40/60. For younger investors, or those able to take more risk because of their situation, sometimes a 70/30 portfolio will work, or even a portfolio with a higher allocation into equities.
Retiring During Market Downturn
But the 60/40 portfolio has been the mainstay of portfolios constructed by advisors.
What happens when markets tank? Theoretically, and as advisors are fond of telling clients, stocks and bonds typically don’t move in tandem. If stocks are down, the bond portion of the portfolio is there to pick up the slack.
Again, theoretically, that means if a client is retiring during a broad equity market downturn, he or she can make withdrawals from bond holdings. That way, clients aren’t selling stocks at lows, locking in portfolio losses, which can take months or years to recover.
Simultaneously, this strategy involves selling the fixed income assets, which are trading at higher prices.
This has been a tried-and-true strategy for generating retirement income.
But does it still work? Should advisors and retail investors consider retiring this strategy?
In a January webinar, BlackRock BLK noted that the traditional 60/40 portfolio as implemented by advisors will fail to generate the expected returns of that past. More alarmingly, BlackRock believes the 60/40 portfolio will increase investment risk.
Redesigning The 60/40
Low yields and low expected returns mean bonds will not contribute to overall performance, nor play their traditional role mitigating the risk of stocks. BlackRock warned that the 60/40 portfolio is likely to generate a lower return that it has over the past decade.
If that’s the case, advisors will have to take steps to redesign the 60/40 portfolio so clients meet their retirement income goals.
In a December 2020 white paper , T. Rowe Price TROW examined the role of bonds in the 60/40 portfolio.
Researchers arrived at some bold conclusions. For starters, given an expectation nominal yields to remain low going forward, investors should look to their equity allocations to generate higher returns. Alternately, investors could also increase equity exposure beyond 60%.
“It appears that the status quo of a 60/40 allocation is expected to lead to a lower nominal return outcome than has been achieved historically,” said T. Rowe Price.
Second, the firm recognized that government bonds continue to have a part in a diversified portfolio, “even with low or negative yields.”
Flat Bond Returns?
However, investors may have to adjust their expectations about the magnitude of these diversification benefits. This is related to researchers’ belief that bond returns will be essentially flat during periods of market stress.
Third, the paper examined redesigning and rethinking the construction of the 60/40 portfolio. It explored adding to the equity positions; investing in longer-dated bonds, which are less affected by current central bank policies; using cash to invest in diversification strategies, such as currencies, corporate bonds or gold.
Ultimately, the brokerage came to the conclusion that low bond yields will continue to affect performance of the traditional 60/40 portfolio. Investors should avail themselves of methods to shore up these portfolios without substantially increasing risk.
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