Alternatives to the 60/40 Portfolio

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Founder and Managing Partner James Demmert discusses how the established 60/40 portfolio strategy has worked for years, but may not be sustainable in the future.

By Paulina Likos, Staff Writer

The traditional 60/40 portfolio allocation strategy has been a long-standing investment approach that has worked for many investors, bringing in reliable gains for years. That said, 2020 has brought about a new market scenario that may challenge this strategy from meeting its standards.

This investment strategy, in which 60% of the portfolio is allocated toward stocks and 40% toward bonds, has been a default way to construct an investment portfolio for many long-term investors.

Investors who adopt this strategy have a majority allocation toward price-sensitive stocks, which tend to be more volatile during market swings but help drive portfolio returns. The other segment is devoted to bonds, typically government bonds, which are often thought of as a stable financial security.

This mainstream investment strategy has gained popularity among long-term investors because the mix of assets and their allocation offer balance and diversification for investment gains in either a bullish or bearish market. According to Vanguard’s calculations based on data from Morningstar, the 60/40 investing strategy with two asset classes, stocks and bonds, between 1926 and 2019, had an annualized return of 8.8%. To achieve this calculation, Vanguard used several different stock and bond indexes as benchmarks of performance within this time frame to find the average annual return of the 60/40 portfolio allocation.

With the many changes this year has brought, most notably the Federal Reserve’s decision to drop interest rates to stimulate the economy amid the health crisis, and the overvaluation of equities, investors are worried their investments will have trouble covering their retirement needs and are skeptical whether this strategy can be relied upon. Consider the points below:

The 60/40 Dilemma

The pandemic has had global ramifications, impacting all areas of the economy differently.

While many sectors have been suffering, we saw the rapid rise of the tech sector in recent months driving high equity valuations in tech stocks. S&P 500 yearly returns are up 14.45%, driven by the index’s sizable weighting of 27.4% in the information technology sector.

While a surge in stocks may come as a positive, it can also pose portfolio risks and compel retail investors to seek other safer methods to invest in – from high-flying stocks to lower-risk securities.

Another risk comes from bonds. Currently, the 10-year Treasury yields slightly more than 0.87% and the two-year yields 0.16%, which may be unsustainable investments for fixed-income investors.

Aaron Sherman, president at Odyssey Group Wealth Advisors in Lancaster, Pennsylvania says a 60/40 investor with a long-term time horizon may be sacrificing growth in a portfolio that’s more conservative than their situation demands.

“With interest rates so low, bonds now contribute very little (if anything) to overall investment return, so a 60/40 investor must accept a lower return for the same amount of risk,” Sherman explains.

Bonds are not serving their purpose, which is to provide income for retirees and hedge against inflation. With economic productivity likely to remain low, it will be difficult for bonds to reach their full potential in this low-yield market environment. This could lead investors to seek other strategies and/or financial instruments to compensate for poor-performing bonds.

Looking ahead, investment returns may be more modest than they were in the past, which has investors thinking: “Will I need to adjust or change their investment strategy altogether, or take on additional risk to have the chance of receiving higher returns?”

Changing Portfolio Construction

There’s more to a 60/40 portfolio than just stocks and bonds.

Diversification of assets should be considered as this strategy helps manage portfolio risk and hedges against volatility. Diversifying assets is an important investment strategy, but maybe that can be done by incorporating other assets apart from the traditional approach.

This brings into question what types of assets, how they are to be allocated and whether investors need to adjust their risk tolerance.

Stocks and bonds are held in a portfolio because they either help drive returns or serve as an offset to risk from the volatility that may arise. Experts say the 60/40 allocation may not need to change, rather the financial securities might require some adjustment or replacement, particularly on the bond side, given the negative impact of bond performance due to lower interest rates.

“If bonds cannot continue to rally or go up in price as (they have) in the last 40 years because interest rates are now near zero, then you have a different profile in terms of diversification,” says Neil Azous, founder and chief investment officer at Rareview Capital in Stamford, Connecticut.

Azous says, “Based on what the pandemic has led to, there’s a wholesale change to portfolio construction.” As a result, Azous and others have been implementing other portfolio allocation strategies to compensate for a portfolio’s underperformance.

He highlights that the 40% part of the 60/40 portfolio, which is traditionally made up of nominal bonds, is being replaced with an inflation protection mix of assets, like inflation-linked bonds, commodities or break-even inflation instruments.

These assets, Azous explains, will hedge against inflation in the event of another economic decline. “The function by the government to protect against a market downturn is going to print more money and that is going to be an inflationary event,” he says. “To hedge against that, you need to replace the nominal portfolio of 40% with inflation-linked products.”

Looking at Other Assets

It may be challenging for some investors to adjust their asset allocation; therefore, they may turn to different financial securities.

Tara Fung, chief revenue officer at AltoIRA in Nashville says retail investors are increasingly interested in holding assets outside of public stocks, bonds and mutual funds and want more diversification and access to high-returning, long-term alternative investments to make up for savings shortfalls.

“They are allocating more of their portfolios toward private market opportunities. Instead of dividing retirement savings into just stocks and bonds, investors are now using their (individual retirement accounts) to invest in startups, securitized art, private real estate and crypto,” Fung says.

Alternatives assets can offer diversification in your portfolio, hedge against market risks and help build portfolio gains. For example, preferred stocks could offer income through dividend payments and help with increasing portfolio returns. Adding exposure to commodities such as agriculture, oil, natural gas or precious metals like gold and silver could be another option for their low correlation with equities.

Individual investors may look to other assets like real estate investment trusts, or REITs, known to increase dividends, which can help with increasing yield for those in retirement. The cryptocurrency market has also been expanding as more investors are growing comfortable with the idea of owning these volatile assets.

These securities could work as alternatives, but investors need to know what their risk tolerance is before adding alternative investments to their portfolios.

James Demmert, founder and managing partner at Main Street Research in Sausalito, California, points to specific assets that could serve as “bond alternatives.” For example, he notes securities such as individual bonds of varying credit quality, like AAA to BB – as rated by rating agencies Standard & Poor’s and Fitch Ratings, who use these ratings to classify the credit quality of an asset. He also says individual preferred shares of very high-quality companies and yields between 3.5% and 4.5%, individual REITs with strong balance sheets and yields between 3% and 5%, and individual utility stocks with strong balance sheets and yields of 3% to 5% do not pose as many risks as stocks but can deliver yields similar to the traditional bond market.

“This diversified group of securities has allowed us to capture what we used to be able to achieve with an all bond portfolio. It is important that our clients are aware that these securities pose more risk than bonds but much less than stocks,” Demmert says.

The Takeaway

The performance of the 60/40 portfolio strategy has been sustainable based on its historical performance, but experts urge investors to look at what assets are in your portfolio and how they are positioned.

To secure your investments in this sensitive economic environment and prepare for future risks, find financial securities that can weather volatility and that fit your risk appetite to create a sustainable balance between your risk and returns.

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Paulina Likos is an investing reporter at U.S. News & World Report, covering investing and asset management. Before beginning her career as an investing reporter, Paulina graduated from Villanova University where she studied political science, communication and business management. Out of college, Paulina spent several years as a risk manager at Fannie Mae, predicting and reducing credit risk for the company.




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