Just before Thanksgiving, something odd happened on Wall Street. Three of the major brokerage firms issued remarkably similar reports declaring the death of the “60/40” approach to investing. What does this mean exactly, and how should you think about it?
By way of background, 60/40 refers to a traditional, and very common, approach to building portfolios: 60% stocks and 40% bonds. Historically, most university endowments, as well as many individuals, have chosen this mix of investments because it offers a reasonable balance of growth (from stocks) and stability (from bonds).
Over time, this approach has worked extraordinarily well. Over the past 95 years, a simple 60/40 mix of domestic stocks and bonds has returned nearly 9%, on average. More importantly, it has been very effective at reducing risk. In 2008, for instance, when the stock market declined 37%, a 60/40 portfolio would have declined just 17%. And this wasn’t an isolated case. The 60/40 approach has delivered reliably in other times of stress, including the Great Depression.
So why is the 60/40 approach suddenly under attack? In my view, this stems from the dramatic growth of index funds. In recent years, investors have been fleeing actively-managed funds—that is, funds run by traditional stock-pickers—and opting into passively-managed funds. The data indicate that this has been a successful approach—and not just for ordinary investors. A simple 60/40 mix of stock and bond index funds has also delivered better results than most university endowments. This includes Ivy League schools, despite their massive size and resources.
For many years, it’s been awfully hard for anyone to top the humble 60/40, especially when it’s implemented with a set of low-cost index funds. But this trend doesn’t serve the interests of Wall Street brokers. Because they pursue a largely buy-and-hold strategy, index fund don’t generate nearly the volume of trading commissions as more active strategies. So it wasn’t a surprise to see Wall Street analysts taking aim at the tried-and-true 60/40. They would like nothing better than to shake investors loose from these simple investments.
But I don’t want to dismiss these analysts out of hand just because they might be biased. It’s important to understand their arguments. While each of the brokers’ views varied, they all focused on the same key concern: Bonds, they argued, are expensive. One broker went as far as to say they are in a bubble. But this is where their arguments’ became shaky. There’s no question that bonds are expensive—yields on U.S. government bonds pay just 1.5% to 2.5%—but the question is how best to respond. The brokers’ prescription was to move money out of government bonds and into corporate bonds and emerging markets bonds—investments that carry far more risk. And they recommend that investors buy more stocks as an alternative to bonds, opting for companies that pay larger dividends.
In my view, this is a dangerous argument. No matter how you look at it, the diversification benefit of government bonds has been strong in virtually every time period. The analysts argue that this benefit could break down, but if you look at historical data, that’s a difficult argument to make. But more importantly, bonds offer investors a guarantee that stocks never will: that they will receive their principal back. And in the case of U.S. government bonds, this has always been the case. So I see it as an extremely unhelpful suggestion to say that investors should move out of bonds and into stocks, or into riskier bonds.
Taking a step back, the reality is that there is nothing magical about the specific percentages in the 60/40 mix. What is important is to build a portfolio of stocks and bonds that is the best fit for you. That means a portfolio that accounts for your specific household cash flow and financial goals as well as your capacity for risk and tolerance for risk. That might end up being 60/40, but it might just as easily be 40/60, 80/20, or any other mix. What is universal, however, is the importance of keeping things simple and maintaining a mix of stocks and government bonds. As much as Wall Street would prefer that you opt into something more interesting, and lucrative for them, I would avoid the temptation.