Here’s How To Replace Them
A new report by Bank of America Securities (a.k.a. Merrill Lynch) has been met with great fanfare in the investment business. The headline is that the conventional wisdom of investing 60% of your portfolio in stocks and 40% in bonds is no longer so wise. Since this has been THE biggest point of my writing over the past decade, I could not help but chime in.
If a tree falls in the forest…
I have been barking about the hidden risks of 60-40 and other “Balanced” portfolios since my second book was published nearly a decade ago (The Flexible Investing Playbook, Wiley, 2010). I have written about 60-40 portfolios in this space several times, including
Destroying The 60/40 Portfolio Myth and
Why 60/40 Portfolios Are In A Slump.
Derek Harris and Jared Woodard, the BOA strategists who wrote “The End of 60/40” keyed in on the changing role of bonds in portfolios. You see, interest rates have generally been falling for about 40 years.
The way bond math works, when you invest with low rate of interest, you have risk that rates will go up. When this happens, bond prices go down. That is something most investors have never seen over a long period of time. However, it is likely from here.
Now, if rates stay the same or go even lower, your bond portfolio’s value will retain its value. However, the rate of growth will be low, since your return will be around that of your interest rate. And, as I said before, rates are very low from a historical context.
New choices for bond investors
Investors are used to seeing one of two things happen in their bond portfolios. Either they make a nice rate of return on the interest rate, or they make that return and more, as rates drop and their bond portfolio appreciates further.
Fast-forward to today, and the choices for bond investors are not “good returns or great returns.” They are low positive returns or negative returns.
But wait, there’s more (to consider here)
Bank of America’s report correctly highlights the problem for bond investors. However, this part of the 60-40 portfolio problem is not new. When I started my own firm in 2012, it was based in large part on finding a way to navigate the end of a bond bull market that lasted for two generations. As the chart below shows, a few months after the firm started, the U.S. 10-Year Treasury Bond rate fell to its lowest level ever, around 1.5%. It was around that level last month, and has not been much above 3.o% since 2012.
Beyond the bull
Translation: the bond bull market is over. Deal with it. But how? This is where my strategy diverts from the mainstream hordes of strategists, pundits and the like. You see, the bond market has been a lost cause for over 7 years. The return on the Barclays Aggregate Bond Index over that time is about 2.8% a year. That is before any expenses you might pay to an advisor, as well as any tax-related reduction in your return. And, as I explained above, that’s the good news!
Beyond the bull, too
Bonds are not the only busted bull market you have to deal with. The interest rate situation is compounded by the fact that the stock market is likely at the end of its 10-year bull market. Since the financial crisis low in the S&P 500 Index back in 2009, stocks were generally on a tear until January of 2018. Then, as noted in my articles many times since, sustainable gains in stocks have stopped.
This means that amid low expected returns for bonds, you really need more from your stock market portfolio (the 60%) to make up for that 40% in bonds. I can’t think of a worse time in my 33-year career to have to rely on a broad-based, buy-and-hold stock portfolio to carry the load!
The reality is that stocks have been masking the weakness in bonds for 7 years. This is not likely to be the case going forward. And, as Warren Buffet famously said, “when the tide goes out, you can see who was swimming naked.” I think a big part of the reason that the alarm bells are going off now is simple: the reality is hitting the radar. And, big financial firms don’t want to be caught, you know, lightly-clothed.
This is especially challenging for those who retired or “pretired” (approaching retirement). You have built all of this wealth, and as you prepare to finally enjoy it, this inanimate object called “the market” could offer you nothing but stress.
What to do about it
The death of 60-40 portfolios is not exaggerated. It is real. That a big firm like BOA has now pointed it out should only serve to accelerate the parade of potential solutions offered by financial advice companies.
Be prepared for them to throw all kinds of 60-40 replacements at you. And know that many of them are either inadequate for you, self-serving for them, or both.
Here is my suggestion on how to replace the 60-40 portfolio. Actually, its more than a suggestion. I have been running portfolios with this philosophy for over 7 years. The key tenets are these:
Stock allocation: less owning, more renting
The 60% you used to have in stocks can still be in stocks. However, the stock bull market threatening to give way to a bear market. The last 2 bear markets would have cut that 60% of your portfolio in half! So, the way you approach the stock portion has to change. Namely, you need to think less about “owning” your positions, and more about “renting” them. That is, shorter holding periods, and a more tactical mindset.
Be ready, willing and able to hedge your portfolio
I have written in this space before about single-inverse ETFs and options, the two primary ways I hedge portfolios. However, there are many more. Seek them out. It might just keep you retired.
60-40, meet Hedged Equity
The bottom line on stocks and bonds is this: bonds are now of limited use, and stocks are likely to be highly-volatile. So in that stock-bond paradigm, the best way forward is to replace the 60-40 portfolio with a hedged equity portfolio. Depending on your investment philosophy and the nature of your liquid assets, this might actually mean you have more than 60% in stocks.
Why? Because the stock market is liquid. More liquid than the bond market in many cases. And hedging it is very realistic, if you know the tools and how to use them. The key is to release from your brain the stock/bond mix, and think instead about varying your “net equity exposure” at different points in the market cycle.
Don’t be afraid to hold cash
With T-bills yielding about as much as long-term Treasuries, cash can be a tactical weapon. Depending on how you use it, you could consider it part of the 60% that used to be in stocks (when you are not fully invested in stocks), as part of the 40% that was in bonds (since you are earning roughly the same yield but with much less potential price downside) or both. And, as rates go up, you keep pace pretty well with short-term bonds and so-called “cash-equivalent” investments.
Creating a hedged portfolio to escape the 60-40 storm that’s coming
Let’s finish by combining all of the above into a format you can consider. For example, you might range from having your stocks and your hedge combine to be 75% as volatile as the S&P 500, to only 25%. Or, you might have a much tighter range. If you are 23 years old and have a few buck to “play with,” this might not be of interest to you. However, if you are nearing or in retirement, you are faced with a new, unique investment climate. Therefore, you may want to do some homework to identify and employ some new ways to provide what the 60-40 portfolio used to.
Related:
8 Crazy Investment Themes For Those About To Retire
