For decades, an allocation of 60% stocks and 40% bonds was a winning strategy that provided strong annual returns with ample protection in volatile markets. The 60-40 plan was easy to execute and stick with through boom-and-bust periods. But a new era in interest rates and inflation means that you may not be able to rely on this formula now. Both stocks and bonds could struggle in the future, and the 60-40 portfolio may not provide high enough returns or reliable risk control to meet your needs. That has prompted many financial professionals to advocate for different allocation weightings as well as diversification into new asset classes. Bottom Line Personal asked three top financial advisers how they are adjusting their clients’ portfolios to improve stability and yields and to enhance returns in the coming years…
Why 60-40 No Longer Works
Over the past half-century, 60-40 has become the gold standard for buy-and-hold investors because it delivered annualized returns nearly as good as that of the S&P 500 Index—9.7% versus 11.1%—with almost 40% less risk. In fact, over any three-year period, the 60-40 portfolio’s worst annualized loss was –7% versus –16% for the S&P 500. Reason: The decades-long rally in bond prices. Back in 1981, the 10-year US Treasury bill yield peaked at 15.84%, then proceeded to slowly decline for 40 years. Since a bond’s value moves up as its yield drops, bonds offered attractive returns and were solid investments during market turbulence.
But in March 2020, bond yields finally bottomed out, with the 10-year Treasury yielding just 0.54%. By that time, a seismic shift was under way in the world economy, hastened by massive fiscal stimulus and worker shortages during the post-pandemic recovery. And inflation ignited—many analysts now expect inflation to settle in the 3%-to-4% annual range for the foreseeable future, far higher than the 1.5% annual inflation we’ve seen since the Great Recession.
This extraordinary turnaround has created an extended bond bear market with yields likely to rise for years (and corresponding bond prices likely to fall).
What this means for investors: Unless you hold individual bonds to maturity, your bond fund could lose money year after year…you can no longer use bonds as safe havens when stocks plunge…and even though bond yields have been rising, they won’t keep up with inflation.
Higher-than-normal inflation won’t hurt just bonds—it eventually will weigh down stock returns as well, since higher operating costs will hurt companies’ profits. By most traditional measures, the stock market is entering this dangerous inflationary period with valuations that are already high by historical standards. A recent Vanguard report estimated US equities will return just 2.3% to 4.3% over the next 10 years…the US bond market, 1.4% to 2.4%.
Three possible ways to restructure your portfolio to meet these challenges…
Allocations: 60% stocks…40% annuities and REITs.
Who is this strategy best for? Investors who need their portfolios to throw off steady, reliable income that they can live on.
How it works: Replace the bond portion of your portfolio with bondlike substitutes, such as fixed annuities, that offer stability and/or steady income. You hand over a certain amount of principal up front to a blue-chip insurance company in return for a series of guaranteed income distributions at a fixed interest rate for a specific period. Fixed annuities often generate more income than bonds of similar maturities. Example: Recently, you could purchase fixed annuities and multiyear guaranteed annuities (MYGAs)—the insurance industry’s alternative to CDs—with yields of 3.35% or more, versus 3% for a five-year bank CD and 3.24% for a five-year US Treasury. You can speak with a fiduciary financial adviser licensed to sell insurance products about what might be the best annuities for your situation.
Important: Consider purchasing fixed annuities with an inflation-protection rider, so that the payout typically rises in conjunction with changes in the Consumer Price Index.
For income diversification, consider adding small exposure to high-quality real estate investment trusts (REITs), companies that own income-producing commercial real estate such as apartment buildings, warehouses, hospitals and hotels. Even though REITs may fluctuate in value, they don’t move in sync with the stock market and they can provide continuous income when stocks or bonds falter, as well as capital appreciation over time. Dependable REIT fund now…
Vanguard Real Estate ETF (VNQ), which invests in 160 blue-chip REITs. Recent yield: 3.04%. Performance: 8.1%.*
Allocations: 30% stocks…40% long-term Treasuries…15% intermediate-term Treasuries…15% commodities and gold.
Who is this strategy best for? Investors who seek steady growth in their portfolio even if both stocks and bonds struggle in the next decade.
How it works: Spread your bets across a broad spectrum of investments that can provide decent returns in any economic or financial-market environment. Lower your stock allocation, and add alternative asset classes to your portfolio that don’t move in lockstep with stocks or bonds, such as gold and commodities (e.g., oil, wheat and lumber). These investments have suffered a long bear market but do well in inflationary periods. ETFs to consider now…
Vanguard Total World Stock ETF (VT). Performance: 9.6%.
iShares Core US Aggregate Bond ETF (AGG). Performance: 1.4%.
SPDR Gold Shares (GLD). Performance: 1.1%.
iShares S&P GSCI Commodity-Indexed Trust (GSG). Performance: –2%.
If you’d rather own just one fund…
Permanent Portfolio Fund (PRPFX) allocates its assets between stocks, US Treasuries, gold and precious metals, and natural-resource stocks. Since its inception in 1982, the fund has returned an annualized 6.2% return with similar volatility to a 60-40 portfolio. Performance: 4.6%.
Allocations: 80% low-volatility stocks and hedge strategies…20% bonds.
Who is this strategy best for? The biggest risk older investors with high bond allocations must consider is lower expected returns in the coming years and the real possibility of outliving their money.
How it works: Lower your bond allocation to 20%, and increase your stock allocation to 80%. Modulate the added risk by investing in low-volatility funds and ones that hedge with derivatives to limit their downside. This allows you to maintain similar volatility to a 60-40 portfolio but creates the potential for higher returns even if bond returns are meager. Keep the remaining 20% of your bond exposure in a diversified fund that owns short-, intermediate- and long-term bonds since it’s hard to time which may do best in the coming years. A low-volatility ETF to use for the majority of your stock allocation…
iShares MSCI USA Min Vol Factor ETF (USMV) has been about 15% less volatile than the overall stock market with strong returns. Performance: 11.8%.
Supplement this low-volatility fund with other funds that use hedging strategies that are common among Wall Street traders to capture a portion of gains in the S&P 500 while limiting potential losses. They include…
Global X S&P 500 Covered Call ETF (XYLD), which writes call options on the S&P 500. It buys the stocks in the S&P 500, then sells call options, which are the rights to buy stocks at a predetermined price. Performance since 2013 inception: 7.3%.
Simplify Hedged Equity ETF (HEQT), which invests in put-spread collars. The strategy involves selling an option against the stocks in the S&P 500, then using the money to purchase a second option to protect against losses. Performance since November 2021 inception: –7%.