The 60/40 Portfolio Explained

Promoted Post

Investing is not something that everyone should consider. It is something that almost everyone should do. If a person wants to build financial stability and wealth, then putting their money to work for them is not a choice. It is a necessity.

Having a savings account is almost always not enough. That is only part of the story, as those with financial experience know that pouring money into different markets offers many potential advantages over having them linger, remaining untouched for years, accumulating low-interest rates that can barely keep up with inflation. According to recent research by Stash, almost 90% of Americans want to build long-term financial prosperity, but less than half know how to go about it. Investing helps those who engage in it save on taxes, stay ahead of money-drop values, and get ready for retirement. Naturally, an individual’s trading goals depend on age, income, and risk tolerance. Based on these, people choose what approach they should implement in their investing endeavors. And per many experts, the best course of action is almost always to diversify, incorporating the 60/40 portfolio as a safe route for most newbies when kicking off their journey of giving their funds a job.

Below, one of the most famous tried-and-true formulas for fortune-creating success gets elaborated on, along with tips on how those new to the investment game should go about implementing this method. What securities should they put together to optimize returns as securely as possible, and how does this method stack up against others?

What Is a 60/40 Portfolio?

The 60/40 formula involves building an investment portfolio consisting of 60% equities and 40% bonds. That is as simple as one can put it. It is nothing more than a rudimentary, in concept, allocation strategy that must get periodically rebalanced, often once monthly, to maintain the noted proportion as each asset class shrinks or grows between rebalances, throwing the mentioned ratio out of whack.

As a rule of thumb, the 60/40 design usually gets applied to domestic investments only, meaning US stocks and a blend of Treasuries and corporate bonds from US firms and US-only equities. Yes, there is nothing wrong with investors opting for a global tactic. That refers to utilizing a blend of sovereign and corporate international bonds and stocks from other markets. But most do not pick this choice due to the unfamiliarity with foreign economies and companies. Moreover, they are fearful of not adequately understanding that rules that govern financial jurisdictions are different than their own.

The chief advantage of the 60/40 method lies in the diversification supplied by the partially uncorrelated nature of bonds and stocks. Diversification gets seen as a vital concept in investing because it helps individuals mitigate risk. For many, a well-diversified portfolio combines different types of investments, and each of these has a specific level of danger of not panning out attached. By allocating assets wisely, one can smooth out returns and potentially improve the long-term health of their portfolio and its performance. Though, it is vital to note that diversification does not eliminate the risk of incurring losses in a declining market. It does not guarantee returns.

The Pros & Cons of the 60/40 Portfolio

As mentioned above, the primary positive of choosing to use a 60/40 mix of stocks and bonds is the gains that come along with diversification. That chiefly stems from the assumption that these asset classes will remain uncorrelated during the portfolio’s investment life, yielding a risk-alleviating benefit that will be most handy. Note that the insertion of bonds in one’s catalog plays a role in increasing the risk-adjusted return. Aside from diversification, this approach has been designed to be simple to implement, requiring only monthly rebalancing and using ETF instruments to make it suitable for systematic retail traders, meaning investors who wish to minimize long-term trading costs. Taxation could be another potential advantage of these portfolios. Yet, that gets heavily dependent on investors’ location and their infrequency of realizing gains because sparse rebalances may make the strategy enticing taxation-wise.

In the past two decades, it has been shown that hypothetical 60/40 catalogs have done similarly well as equities-only portfolios. And they have accomplished this by accumulating less risk than the latter. Such allocations can also reduce downturn impacts, helping investors avoid selling amidst equity market crashes.

What many veteran investors do not like about standard 60/40 portfolios is that they mainly utilize US-only assets. Research shows that these collections of financial investments can also suffer from sizable drawdowns over set timeframes that can be difficult for most investors to tolerate. Also, their inception date is a super sensitive aspect that can substantially affect this strategy’s performance. For example, if, on a price-earnings basis, the invested stocks are expensive when they enter the portfolio, that may have a drastic impact on the overall returns.

Some also worry about many analysts speculating that the combo of projected expensive stocks and negative bond yields in the future will have a rough time beating inflation. Most experts are doubtful that a 60/40 portfolio can perform well as a viable investment tactic in a high inflationary environment as the one that gets expected to materialize in the next decade. That is particularly troublesome because bonds and stocks become highly correlated in periods of high inflation. And when stocks disappoint, bonds are unlikely to hedge. Without question, the positive effects of investment-grade bonds can falter when inflation jumps and past performances offer no guarantees for future results. So, people should keep that in mind. Per Heider College of Business, professor of finance Robert Johnson – going forward, a 60/40 portfolio will probably underperform all-equity portfolios in the long term.

How to Benchmark the 60/40 Portfolio

The 60/40 portfolio falls into systematic trading. That is something that the majority of people out there have heard of regarding retirement planning. It is a system of active management

entailing shifting assets, frequently rebalancing them depending on market fluctuations. Therefore, the common term used is tactical asset allocation (TAA). It is perfect for those who wish to minimize day-to-day work but prefer to check the status of their investments periodically and make appropriate moves. Nevertheless, this approach still relies on traders having a continuous awareness of the behavior of various asset classes and a decent understanding of past and current macroeconomic trends.

Since the 60/40 investment style necessitates regular rebalancing, that motivates the concept of a strategy benchmark. That can supply a terrific comparison mechanism against one or multiple trading tactics. And many in the TAA space use the 60/40 catalog as their benchmark to see how their strategy is performing. They believe that domestic market indexes, geographically-dependent single asset class instruments, make less sense to factor when considering an investing system involving a broad range of asset classes. Though dominantly, a market index is a typical benchmark for almost everyone, as it provides a starting point for investors that can get looked at on an ongoing basis, helping them run their investments from the perspectives of both return and risk. Of course, the most popular indexes used for this are the Dow Jones Industrial Average, the Russell 1000 and 2000, and the S&P 500.

The reasons to perform benchmark comparisons when investing are vast since gauging securities performance is a crucial part of the investment process. Nonetheless, knowing when an investment incurs a loss or attains a gain is only a tiny part of the picture. Comparing it to the border markets gives a better view of the goings-on and accurate data for one’s next decision. Thankfully, virtually all robo-advisor software nowadays features benchmark columns that use various indexes to provide a better portfolio life overview.

What Types of Stocks & Bonds Should a 60/40 Portfolio Include?

Growth stocks are usually the go-to option, and today, these most often represent equity in tech companies. They can be quite volatile because the truth is that no one knows what will go mainstream and if foreign companies will come up with better solutions simultaneously or not. That is why tech growth stocks (start-up ones) can be risky, and when a recession arrives or during a bear market period, they can lose much of their value quickly.

Stock funds are another way to go. They are less risky, involve less work, and can give away more stable returns. The same applies to mutual and bond ETF funds. These are premium picks for those who wish to diversify without having to analyze individual bonds. Newbies should know that while bonds fluctuate, bond funds are primarily stable. They mainly move as a response to changes in the prevailing interest rate. Bonds issued by corporate issuers are far riskier than those coming from government issuers. But there are still safe options that originate from the corporate sector also.

Should Investors Rethink the 60/40 Approach?

One of the main reasons for this may be that treasury yields are now low, and many believe that the current ultra-low interest rate environment will not disappear soon. For all buy-and-hold investors, bonds are no longer the same reliable income source they were before.

Fears of inflation rising again also spell bad news for fixed-income trades, as that customarily leads to decreases in valuations of bond portfolios because it increases bond yields and takes chunks away from returns. Furthermore, stocks and bonds do not supply the same degree of diversification they did in the past. The premise of the 60/40 system is that bonds and stocks get negatively correlated, with stocks hedging against inflation and bonds against risks to growth. And the Bank of America recently projected that the negative correlation between these two securities should change soon.

Alternative Strategies to Consider

Corporate debt offers decent returns and often gets overlooked by portfolio managers and unsavvy investors. But preferred shares supply fixed payments similar to bonds and should also not get avoided.

In the past decade, multiple high-end brokers, like famous American financial commentator and radio personality Peter Schiff, have pushed for alternative investments. These are gold, silver, various commodities, and real estate. Schiff has been a heavy proponent of gold, as he thinks that precious metals deliver a hedge against market downturns. They are unlikely to lose value due to their inherent qualities and many uses.

Farmland is a low-volatility asset class that many are also talking about nowadays, and those that make this investment can get regular rent payments, money for the sale of crops, plus price appreciation when assets get sold. Technically, this is the oldest asset class, but for some reason, it gets neglected by many investors. Or maybe it is because the investment is generally illiquid until exit.

To Wrap Up

In most financial experts’ eyes, the 60/40 portfolio is a good route for investors whose risk tolerance does not permit them to go after 100% equity allocation. It is a tactic that better suits those who are in the middle of their investing career. These are people who may have the inclination to toe the line between taking dramatic risks and seeking super-stable investments. Essentially, individuals who favor a slow-and-steady win the race path to investing.

The entire point of this system is to guide investors through volatile conditions, to minimize risk while producing returns even in periods of sizable market fluctuations. It is an Okay approach for those with low-risk tolerance who still crave satisfactory growth potential.