Market Corrections & The 60/40 Portfolio
"Experience is what you got when you didn’t get what you wanted"
- Howard Marks
“A clear conscience is a sure sign of a bad memory.”
- Mark Twain
Hey Readers!
Short one this week since I’m been super busy. It’s a fun one though, hope you enjoy!
Have a good weekend,
- Ryan
Street Stories
The 60/40 Portfolio
I’ve spent most of my professional career as a stock picker so I’m naturally biased towards equities. To me, bonds are… kinda yucky.
That’s not to say I don’t think they have a role in people’s portfolios.
The idea is that stocks and bonds have a low-ish correlation. Often times when stocks do poorly, bonds do ok and thus they add some nice diversification. Portfolios structured this way are increasingly more common as individuals age, since preserving wealth is more important than absolute returns and there are also material tax savings if used appropriately1. I know, lame right?
1. Bond coupon payments are taxed as income and retired individuals - in low tax brackets - can benefit from this relative to dividends and capital gains.
So, ok, bonds are fine. Whatever.
The big issue I have is that a lot of investment advisors and wealth managers get a little too pushy with their portfolio construction and overdo it with the bonds: The classic example being the 60/40 portfolio.
In a 60/40, the advisor puts 60% of the clients assets in stocks and 40% in bonds. As you can see above, with the S&P representing the stocks and the Bloomberg US Aggregate Bond Index subbing in for the bonds, that’s not exactly an ‘optimized strategy’.
In the 30 years since May 2nd 1995, the S&P 500 is up +1,178% while the bond index is only +261%. Slapping 40% of your money into bonds would decrease your return by 31% to +811%. Ie: Not good.
Note: Data relates to ‘total return’ inclusive of dividend and coupon payments reinvested.
And if the 60/40 is so good at adding diversification, with the market going haywire surely this would be the time for it to shine - and it’s definitely done ok.
Since the market peaked on February 19th, the S&P 500 Total Return is down 7.0% compared to only 4.2% for the 60/40. 🫠
But while that +2.8% outperformance that the 60/40 has had over the S&P Total Return since mid-Feb is moderately impressive, you don’t have to zoom out too far to see just how much of a detriment it would have been to have been holding bonds recently.
If we look at the rolling 1 year return of the 60/40 versus the S&P 500 Total Return, 27% of the time since 1993 it’s outperformed.
For the rolling 5 year return since 1998, the results are even more impressive at 34% of time - mostly due to the market taking its time lapping the highs from 2000 (DotCom Bubble) and 2007 (Great Financial Crisis).
But ‘34% of the time’ doesn’t capture the full picture, since the excess return generated by the stocks-only portfolio over the 60/40 has been significant the majority of the time.
As you can see above, on a rolling 5 year basis the stocks-only portfolio has averaged an 11.1% outperformance over the 60/40 - not exactly chump change!
Ryan’s Thoughts: As much as I joke around that we’d be better off without them, bonds play a vital role in portfolio construction. As an individual approaches retirement, an ever increasing allocation isn’t just prudent; it’s a necessity.
The issue I have is that younger investors and savers are over allocated to bonds, either by societal pressures or by investment advisors acting poorly. The latter I blame for two primary reason:
They often do not fully understand the service they should be offering their clients - and clearly haven’t taken the time to research the issue.
They don’t want to get fired
The last one is particularly terrible in my opinion. Not getting fired - and thus continuing to take a cut of the investors assets every year - is often more of a priority for the advisor than the most prudent long-term strategy for the individual.
As an example, imagine you can pitch your client two strategies: The first will outperform the market by 3% a year when the market goes up and underperform the market by 3% when it goes down. The other strategy does the opposite; underperforming by 3% in up years and outperforming by 3% in bad years. What should the advisor recommend to a 33 year older client?
Well, given that up years happen significantly more often than down years (the S&P closed higher in 35 of the last 46 years - or 76% of the time) and that they likely won’t need to touch their money for another 30 years, the first strategy is generally superior for the client.
But clients don’t usually fire their advisor in good years - even if they’ve left a lot of money on the table! They typically fire them when markets go down and they go down more. To me, that’s a big reason why young investors get saddled with overly conservative, bond-heavy portfolios - even when that’s clearly against their long-term prosperity.
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Absolutely agree! Unfortunately many in our wealth industry hides behind the 60/40 model and pretends this is investment advice and charges quite a lot of fees. Buyers beware if their goals and risk profile are really considered and if their portfolios are truly “optimal” and have a high chance of meeting their goals.