What's So Magical About a Traditional 60/40 Porfolio? by Scott Stolz, CFP, RICP (week 40)

 

When building any type of portfolio, the financial services industry almost always assumes that a portfolio made up of 60% stocks and 40% bonds is the proper place to start.  This is especially true with a retirement portfolio since by definition pre-retirees and retirees are older and are assumed to be more conservative.  But is this really the right way to go?

Before I tackle this topic, I should acknowledge upfront that I’ve never bought a bond in my life.  And I likely never will.  In the long run, stocks always outperform bonds, so I’ve never seen the point of adding bonds to my portfolio.  Don’t get me wrong.  There were certainly time periods such as the financial crisis of 2007-09 when I wish I owned bonds instead of stocks.  But no one can predict with any accuracy when such times will occur.  Now that doesn’t mean I don’t understand the potential benefits.  Proponents of a 60/40 portfolio will highlight the following benefits:

1.      It adds diversification to a portfolio – especially in time period when bonds outperform stocks

2.      It smooths out returns by reducing the volatility that comes with a portfolio of only stocks.  As we’ve seen over the last 6 months, a portfolio of 100% stocks can have sharp swings both up and down.  As I write this week’s blog, the Dow Jones is down another 475 points today.

3.      The smoother returns can help investors stay the course and avoid selling stocks at the wrong time.

On top of all of this, a 60/40 portfolio has performed well over time.  Historically, returns have averaged between 7-8% per year.  Advisors don’t lose clients if they can consistently provide such a return. 

Studies have shown that once investors reach the age of 50, they start to become increasingly conservative regarding their investments.  I didn’t expect to fit this trend, but I did.

Given the compelling benefits of the traditional 60/40 portfolio and the fact that I’ve become more conservative, why don’t I own any bonds?  It’s simple really.  By adding a significant amount of protected lifetime income to my portfolio, I’ve achieved the same benefits without the use of bonds.  Essentially, the annuities I own that will provide this income replace the bonds of a traditional 60/40 portfolio.

Interestingly, most analysts would look at my portfolio and conclude it’s too aggressive for a retiree.  Most portfolio analytics tools would not include the annuities providing my lifetime income.  In fact, some firms may not have a way to show any value at all on their client statements.  Only the other assets I own would be analyzed when determining if my portfolio meets my risk tolerance and objectives.  Therefore, my portfolio would like be analyzed based solely on my other assets.  When my retirement portfolio is looked at in that manner, one would conclude that it’s 100% stocks.  But there is a value to a stream of lifetime income.  Let’s look at a 65-year-old female that is getting $50,000 per year in Social Security benefits.  She has a life expectancy of 23 years.  Therefore, she would expect to get $1,150,000 in total benefits.  In today’s dollars that stream of income would be worth about $750,000.  That’s a lot of money.

When I look at the structure of my portfolio, I count the value of my future income as an asset.  Therefore, from my perspective, my portfolio is much closer to a traditional 60/40 portfolio than it would appear.  Not only is it diversified, but because my income isn’t impacted by the ups and downs of the stock market, my returns are smoothed out, and I don’t feel compelled to sell any stocks just because the market has hit a bad stretch.  Perhaps more importantly, I don’t feel a need to cut my spending every time the value of my remaining assets falls.  Studies have shown that many people that rely on the traditional 4% withdrawal rate from their retirement income portfolio end up underspending in retirement.  Their retirement plan might say they are still “OK,” but something psychological happens when that $1 million portfolio suddenly becomes $900,000.  Even if that lower value is within the bounds of the plan, there is this natural tendency to cut back on spending until the portfolio grows back to $1 million.

The Importance of Being “Aggressive” With the Rest of the Portfolio

My retirement planning approach makes sense only if all of the interested parties include the value of the income stream when analyzing your portfolio.  If they don’t, then industry norms are going to push your advisor to use the 60/40 approach when structuring the assets that are not providing your income.  In reality, that will leave you with a portfolio that is more like 30/70 than 60/40.  In short, it’s going to be far too conservative and will not provide the growth you need to keep up with inflation.  I believe this is a shortfall of the financial services industry.  Because the 60/40 portfolio has become the accepted structure for all but the youngest and/or most aggressive clients, such a structure carries very little regulatory risk.  Advisors can get in big trouble if they invest a client’s assets too aggressively but have very little exposure if they invest too conservatively.  Clients sue their advisor because they lose money.  They don’t sue because they made too little.  As a result, most advisors don’t feel comfortable dedicating the remaining retirement assets to 80% or even 100% equities.  They therefore conclude that adding protected lifetime income so adversely affects the expected performance of the portfolio that they conclude that it is not a viable solution for many of their clients.  Sadly, the end result is that far too many clients still wonder if they will be “OK.”