The traditional 60/40 stock/bond allocation, long the linchpin of portfolios, is broken, and it’s not coming back together any time soon.
As investors, we have to move on.
I know, I know. The 60/40 portfolio is actually having a decent 2016. A 60% allocation to the SPDR S&P 500 ETF (SPY) and a 40% allocation to the iShares Core US Aggregate Bond ETF (AGG) would be up about 3% year to date.
Don’t get used to it. Looking ahead, the math doesn’t work out.
Let’s take a look at the numbers. Back in 1980, the 10-year Treasury yielded a fat 11.1%, and stocks sported an earnings yield (calculated as earnings / price, or the P/E ratio turned upside down) of 13.5%.
This implied a back-of-the-envelope portfolio return of about 12.5% per year going forward, and for much of the 1980s and 1990s that proved to be a conservative estimate.
The 60/40 portfolio was a great allocation for the nearly four decades leading up to today.
But what about today? The 10-year Treasury yields a pathetic 1.6% and the S&P 500 trades at an earnings yield of just 4%. That gives you a blended portfolio expected return of an almost embarrassing 2.8%. That’s just barely higher than the rate of inflation.
Now, nothing about these returns estimates is set in stone. It’s not impossible that stocks could continue to enjoy future returns more in line with their past returns, however improbable it might be.
But I can’t say the same for bonds. Starting at a 1.6% yield to maturity (or even the 4% you might find on a mid-grade corporate bond) it’s impossible to have returns going forward match anything close to the returns of the past.
Bond yields would have to go negative, and I don’t mean the -0.15% we see today on the Japanese 10-year bond. I’m talking -5% or -10% or even more. That’s not going to happen.
So if the traditional 60/40 portfolio is dead, what are investors supposed to do with their money?
I’d offer the following suggestions:
1) Take a more active approach to investing
To the extent you invest in traditional stocks and bonds, don’t be a buy and hold investor. Yes, low fees are great. But in 2008, when the market was rolling over, did you really care that your index fund only charged you 0.09% per year in management fees?
Instead, try a more active strategy, perhaps focusing on value or momentum.
Here at Dent Research, we specialize in momentum strategies. Rodney’s Triple Play Strategy uses a sophisticated “relative strength model” to find stocks showing upward momentum, regardless of what the market is doing.
Likewise, Adam O’Dell’s Cycle 9 Alert identifies and profitably follows trends, be they bullish or bearish. Adam also urges investors to take emotions off the table completely to avoid irrational investment behavior and to see the trends through. He goes into detail about this strategy in his latest report: “The Typical Investor Sucks Wind.”
2) Invest outside the market
If you’re willing to get your hands dirty, consider starting your own business. Some of the best business ideas were born in very difficult economic times. Yes, starting your own business is “riskier” than working for a paycheck. But having a day job isn’t exactly risk free… just ask anyone who works in oil and gas today.
If you’re looking for a business idea, circle back to Harry’s demographic work. Ask yourself, what will the baby boomers need as they age… or what will the millennials need as they settle down and start families? There will always be an opportunity out there for someone willing to hustle.
3) Consider a truly alternative asset allocation.
The 60/40 portfolio has stood the test of time. Or has it?
That’s actually pretty debatable. In the 1970s, both stock and bond returns were terrible. Though what would you expect; this was the decade that gave us earth tones and disco, so clearly the world had gone more than a bit mad.
In any event, today’s market is fundamentally different than those in decades past. We’ve never been in a world of negative interest rates and central-bank-driven economics. A different era needs a different allocation.
For a long time, I’ve advocated using market-neutral and long/short strategies in lieu of bonds. A well-constructed long/short portfolio will do a lot of what you would want a bond portfolio to do; it will reduce volatility and give you a stream of returns that are mostly uncorrelated to the stock market.
In a long/short portfolio, you buy stocks that you expect to rise in value and sell short stocks that you expect to fall. But since your portfolio is roughly balanced, you’re pretty well insulated from broad market moves. Your portfolio wins or loses based on the movements of the individual stocks. Whether the market goes up, down or sideways doesn’t matter much.
Forensic Investor is not fully market neutral; its recommendations will be net long or net short based on John’s view of the market.
But it absolutely offers a hedged alternative that stands to make money in bull and bear markets alike.
Will a collection of strategies like these beat the returns of a 60/40 portfolio in the years ahead?
We’ll certainly find out soon enough. But the way I look at it, at least they give you a fighting chance to earn a respectable return.
I definitely can’t say the same for a 60/40 portfolio.
Portfolio Manager, Boom & Bust