The Federal Reserve is continuously tightening and affecting fixed-income investments. It has decided to reduce the rate of return for bonds with at least five years of maturity. Generally, the 60/40 portfolio has delivered excellent performance. However, tough times must make investors wary of being complacent. For the past few years, strategies are plenty as alternatives to the 60/40. Some methods are beneficial alone, but building a portfolio of other assets can offer a better range of risk and return profiles.
Many investors follow the 60/40 portfolio — 60% equities, 40% bonds — for their retirement investing. Its principle lies in allowing the growth of wealth through stocks and reducing risks through fixed income. It uses high credit quality, short-term bonds to alleviate the risks of stock investing. Traditionally, bonds generate income for investors.
However, the 60/40 rule became unpopular in the late 1990s, specifically during the dot-com boom. The stock prices continued their upsurge, and some investors began to question their decision. They thought that their bonds investments were pulling down their portfolio performance.
Today, financial advisors promote investing in assets that meet their clients’ financial goals, time horizons, and risk tolerance. They use mutual funds or exchange-traded funds (ETFs) to level the returns and diversify the portfolio. Clients take the risk assessment quiz to know where to put their money. For young investors or risk-takers, they may use the 70/30 ratio or even a higher allocation into stocks.
60/40 Portfolio: A Proven Strategy
Advisors had been using the 60/40 portfolio for years. They believe that bonds and stocks don’t move in the same direction. If the stock market is experiencing a slump, the bond prices will move upwards. It means that if investors are retiring during a downturn, they can sell their bond inventories to protect their stock holdings. They don’t sell their stocks at low prices to lock in portfolio losses. It may take months up to years for their investments to recover.
Selling the bonds is an excellent strategy because when the stock market is declining, the bonds trade at higher prices. It is the tried-and-tested approach for earning retirement income. However, the current conditions can no longer provide the expected returns of yesteryears. The 60/40 portfolio may even generate more investment risks to the investor.
Dynamic Strategies That Offer Added Value
By ensuring the appropriate selection of assets and adding or subtracting exposure to equities, dynamic strategies can provide more value. For instance, robust underlying fundamentals can allow investors to go long. Mixed fundamentals mean applying a partial hedge. Weak fundamentals require a full market hedge to protect investors from any downdrafts but continue to provide excess returns via security selection.
The bearish strategy for poor fundamentals requires eliminating all equity exposure and investing them in U.S. Treasury Bills. Investors can have potential profits because they have high-quality cash and short positions in equity futures.
Revamping the 60/40 portfolio
The bonds cannot provide the essential support to stocks because they now have low expected returns and yields. They do not add to the overall portfolio performance. Moreover, they no longer mitigate the risks of stock investing. Today, the 60/40 portfolio is most likely producing a lower return compared to the past decade. Financial investors must redesign it to help their clients meet their retirement income objectives.
Because nominal yields will maintain their low expectation, investors can allocate more of their funds to equity to earn more income. They can increase their exposure to more than 60% of their portfolio. However, government bonds must occupy a part of the portfolio pie, even if they offer negative or low yields.
Historically, the 60/40 asset allocation has delivered robust returns. However, a dominant issue with it is that its correlation to equity market risk remains high. Portfolio returns have been substantial because the stocks offered a 13% annual compounded rate. Fixed income showed minimal stock market correlation with less than 3% yield. Nevertheless, excess returns depend on the prevailing interest rates.
The strategy may seem optimistic on an expanding global economy and increasing inflation. Portfolio correlations will stay tied to the stock market unless investors reduce their exposure significantly. Dynamic strategies can achieve dramatic returns by increasing fixed income exposure, especially now that the central bank is in its tightening cycle.
Investors must adjust their expectations about the benefits of diversification. Bond returns will be flat when the market is undergoing too much stress. Rethinking and redesigning the 60/40 portfolio is vital. Adding more money to the equity positions and longer-dated bonds not affected by central bank policies is an excellent strategy.
Low yields from bonds will persist and affect the conventional 60/40 portfolio performance. Investors must use methods to reinforce their investments without increasing risk substantially.
Some investors may believe that the 60/40 portfolio is appropriate for stock and bond allocations. However, it can also provide an attractive starting point for liquid alternative positions. The portfolio may rely heavily on equity performance without depending on the higher price of stocks. In cases when fundamentals start to deteriorate, investors may earn positive returns when the values of traditional assets fall.
Investors may want to shift a higher allocation of their fixed income to credit, assuming that the central bank will cap any downside. However, discarding a focus on fundamentals due to ongoing near-term uncertainties may not be beneficial to them. Trying to get out of government bonds into the credit markets requires a focus on high-quality segments. Investors must be mindful of their dependence on the support of the central bank.
Investing in physical assets like real estate is another strategy because it offers attractive yields for low liquidity. Investing in core infrastructure has proven to be a remarkable defensive and consistent income stream even during financial crises and recession. It can offer yields of up to 7% with the potential to access regulated or contracted cash flows. It can play a significant part in the investment portfolio if investors are comfortable with the lack of liquidity.
The 60/40 portfolio allocation is an excellent and prevalent strategy. However, it has not been consistent in providing high returns. Due to the prevailing market and economic conditions, investors may want to change the mix slightly to generate a higher income.
Government bonds may offer some diversification, but they also provide less upside potential and income. They are also vulnerable to a possible upsurge in growth or inflation. Adding other strategies will allow the investors to increase returns and risk-adjusted earnings with the conventional stock and bond portfolio.
Investing in real estate, infrastructure, and credit markets are a few possibilities for investors searching for assets they can include in their portfolio. If correctly studied, these assets can give a substantial boost to the portfolio. Diversification has always been a time-and-tested strategy to mitigate the risks of investing.
About the Author
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