Op-ed: Traditional 60/40 portfolio has actually reached its expiration date

  • High valuations of stocks and low yields on bonds mean the next decade will be challenging for investors to protect the real (after-inflation) value of investments.
  • An investment portfolio of all equities will likely outperform inflation over time, but would be volatile. Think about a reliable source of liquidity such as a portfolio of cash and cash equivalents, like very short-term, high-quality bonds.
  • The traditional 60/40 portfolio will likely neither grow in excess of inflation nor provide much downside protection.

In the long run, inflation is an investor's biggest threat.

Inflation erodes the purchasing power of money. Even modest inflation at 3% annually halves the value of money in 24 years. So outpacing inflation is the primary goal for long-term investors.

Beating inflation was not a problem over the past decade. Stocks soared 360% in the past 10 years, averaging more than 16% per annum. No wonder valuations are near record levels. Bond yields, low to begin with, have fallen further over the decade: 10-year Treasurys yield just over 1%, municipal bonds less than 1%.

Outpacing inflation over the past decade was easy for investors, but the high valuations of stocks and the low yields on bonds means that the next decade will be much more challenging for investors to protect the real (after-inflation) value of their investments.

More from FA Playbook:

Here's a look at other stories impacting the financial advisor business.

  • 'Thematic investing' has skyrocketed. How to capitalize on the trend
  • 'Investor alpha' is the most important financial strategy for 2021
  • Here are 5 lessons the pandemic taught this financial advisor

Today, high-quality bonds, a mainstay of most portfolios for their consistent yields and downside protection, offer neither yield nor an inflation hedge.

Adjusted for inflation, yields on high-quality bonds are negative.

In other words, investing in Treasurys is guaranteed to earn a full 1% less than inflation over the coming decade. Investors in Treasurys are guaranteed to lose value as will investors in municipal bonds and even in high-grade corporate credit.

Many investors may ask: "Don't high-quality bonds provide protection during an equity sell-off?" The answer is: "Not anymore." With yields so low, bonds can no longer rally when stocks sell-off.

About 20 years ago, Treasurys rallied 31% and the Aggregate Index rose 18% as equities fell 49% during the internet bubble collapse. At the start of the pandemic last year, stocks dropped 34%, but Treasurys gained just 5% while the Aggregate Index actually lost 3%.

High-quality bonds provided little or no hedge when the stock market plunged because yields were so low. Yields are even lower today, so investors should expect bonds to offer even less protection in an equity decline.

High-quality bonds earn less than inflation and offer little protection in an equity sell-off, and investors should avoid owning them. However, investment portfolios are not only about long-term growth. For many investors, portfolios are also sources of liquidity to meet expenses.

An investment portfolio of all equities is likely to outperform inflation over time, but that would be a very volatile portfolio, subjecting investors to the risk of having to sell stocks to pay expenses at a moment when stocks have declined.

The traditional portfolio of 60% stocks, 40% bonds was meant to solve the twin objectives of long-term capital appreciation and capital preservation. But given today's valuations, that 60/40 portfolio is likely to achieve neither objective, so investors need to change their thinking.

Capital appreciation above inflation will require owning equities and some equity-sensitive securities like high-yield bonds. This portfolio will be volatile, but can offer investors the best chance of outpacing inflation.

Because of this volatility, this portfolio will not be a reliable source of liquidity for current expenses. For that, investors should also hold a portfolio of cash and cash equivalents, such as very short-term, high-quality bonds. The yields will be modest, and below inflation, but the purpose of this portfolio is to meet current expenses.

Investors can think about holding six to 12 months of anticipated expenses in this portfolio, replenishing from the long-term portfolio under normal circumstances, and delaying that replenishing when equity markets sell-off.

The traditional 60/40 portfolio that served investors well for most of the past 40 years has reached its expiration date.

With yields at all-time lows and valuations near all-time highs, the traditional 60/40 portfolio will likely neither grow in excess of inflation nor provide much downside protection. Investors should hold cash to meet current spending needs and embrace a more volatile portfolio of equities to achieve real long-term growth.

High-quality bonds, that middle ground between cash and stocks, have been squeezed out of their usefulness.

 — By Michael Rosen, chief investment officer of Angeles Investments and Angeles Wealth

Source: Read Full Article