Why The Traditional 60/40 Portfolio Is In Danger (And What You Can Do About It)
There are other portfolio strategies you should consider if you want to diversify your investments.
Whether the market is reaching an all-time high or is crashing, one question always pops up: Is now a good time to invest? Should I stick with the traditional 60/40 portfolio or try something else? With the market being at an all-time high, prospective investors anxiously wonder if this is the top and kick themselves when they see the market move higher. And when markets are crashing, the interested investor rarely has the psychological strength to buy in and risk seeing their holdings crash.
The idea of diversification and the 60/40 portfolio was created in part to answer the question of when is a good time to invest. But times have changed and it seems that the traditional 60/40 portfolio will have to change with it. So what are the possible alternatives to the traditional portfolio allocation? Let's dig in.
What Is the Traditional 60/40 Portfolio?
The 60/40 portfolio is one of the longest-standing and widely followed allocations for investors. Financial advisors and grandparents extol the virtues of this and have done so for many years. The idea is that 60% of your investments should go to large-cap stocks, while the other 40% should go to U.S. Treasuries and other investment-grade bonds.
Its simplicity makes it so attractive. Investing in stocks produces much more gains than bonds but is much riskier. To smooth out the market crashes, you invest in bonds to cushion your portfolio from significant downturns. And you enjoy income from the bonds all the while. You should come out ahead as your portfolio drops significantly less than someone who is all-in stocks over the long term.
The idea of diversification was created in part to answer the question of when is a good time to invest. In general, you should always have investments with a long-term horizon in mind. However, markets don't always go up, and the downturn can provide a nasty surprise. This is especially true for investors who get in at the wrong time. For this reason, it's recommended that inexperienced investors use a financial advisor to keep their portfolios up-to-date. You can easily find an advisor through services like Paladin Registry .
Why Doesn't the 60/40 Portfolio Work Anymore?
Unfortunately, we are facing a combination of circumstances that may mean that the 60/40 portfolio is actually a huge danger to investor’s long-term nest egg.
- Interest rates are at their lowest point in history and central banks have made it clear that this will be the new normal for the foreseeable future. Due to record low-interest rates, investors no longer get much of an income from bonds at all, eliminating one of the reasons this portfolio was so attractive in the first place.
- And with such low-interest rates, inflation becomes a major problem for the 60/40 portfolio. With even the slightest uptick in inflation above current interest rates, investors will lose money in real terms on 40% of their portfolio. That means 60% in stocks will have to work that much harder just to offset the loss.
- As interest rates go lower, the value of bonds increases. This sounds great for the portfolio, however, interest rates are already at or near zero. This means that interest rates likely won’t go lower and by extension, bond values won’t go any higher.
Keep in mind that interest rates have steadily declined for 40 years, meaning an unprecedented 40-year bull market in bonds. As interest rates essentially hit a floor, it becomes more and more likely that interest rates will start going the other way at some point, lowering bond values with them.
Alternatives to the 60/40 Portfolio
Thankfully, the 60/40 portfolio isn’t the only portfolio allocation out there. Today it is easier than ever to invest in a number of asset classes that offer even more diversification.
One asset class every investor should consider adding to their portfolio are REITs or real estate investment trusts. These are investment vehicles that pool money together in order to invest in the real estate market. By law, they must payout at least 90% of their earnings in dividends. That means investors can earn a handsome income while benefiting from real estate’s resilience to inflation thanks to it being a real asset. You can start with REITs investment with Origin Investments.
Investors should also look into a group of blue-chip stocks called the Dividend Aristocrats, who have managed to raise dividends consecutively every year for at least 25 years. Many of these companies are high-quality brand names such as Coca Cola which are likely to survive market crashes while paying investors a good dividend as a source of income.
The final tweak comes in the form of commodities. This is a broad category, but thankfully there are a number of ETFs that track general commodities indexes. Alternatively, investors can buy ETFs that track the most important commodities such as gold and oil.
While commodities are the most volatile of the bunch, they also provide the very best in inflation protection and in the case of gold, can be decent protection against recessions. Due to their volatility, it is recommended to only hold a small portion of your portfolio in commodities.
Alternative Portfolio Compositions
There is no one-size-fits-all for investors. Your portfolio should be unique to your risk tolerance and your goals. A young person looking to maximize his gains and a retiree looking to maintain their wealth have two very different goals and likewise should have two different portfolios. Working with a financial advisor or wealth manager can help you get a better idea of what strategy could work for you.
That being said, here are a few broad examples for different situations in order to inspire your own portfolio constructions:
The Aggressive Investor
This is a portfolio example for investors who are willing to take on more risk. For example, someone in their mid-20s who has a lot of time before they will need to access their investments might want to be more aggressive in their investing approach.
- Equities: 55%
- REITs: 25%
- Gold: 15%
- Treasuries: 5%
The Income Investor
This investing approach is best for investors who want to create a steady stream of income coming in. It can work for investors who are mid-career or anyone who wants to maintain their investments at a constant pace.
- Dividend Aristocrats: 50%
- REITs: 25%
- Treasuries: 10%
- High Yield Bonds: 15%
The Balanced Investor
For investors who want to invest in a little bit of everything. Having a variety of investments can help you diversify your portfolio. It also helps balance your portfolio out in case of volatility in equities, while giving you room to grow your investments.
- Equities: 50%
- REITs: 20%
- Treasuries: 20%
- Commodities: 10%
New Problems Need New Solutions
Whether we know it or not, we are entering a new phase in financial history. Interest rates have never been this low, and no one is precisely sure what the long-term implications of that may be. Regardless, the 60/40 portfolio has far too many risks associated with it in today’s environment for it to continue being a good option for investors.
If you want to be truly be protected from potential financial danger, you'll need to factor in the changes in the world. Thankfully now has never been a better time for individual investors to access different asset classes. As always, do your own due diligence and build a portfolio for your own goals.