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Cut the Bonds?

Adam M. Grossman  |  January 12, 2020

JUST BEFORE Thanksgiving, something odd happened on Wall Street. Three of the major brokerage firms issued remarkably similar reports declaring the death of the “60/40” approach to investing. What exactly does this mean—and should you be concerned?

By way of background, 60/40 refers to a traditional and very common strategy for building portfolios: 60% stocks and 40% bonds. Historically, most university endowments, as well as many individuals, have chosen this mix of investments because it offers a reasonable balance, with growth coming from the stocks and stability from the bonds.

The approach has worked extraordinarily well. Over the past 95 years, a simple 60/40 mix of U.S. stocks and bonds has returned an average of nearly 9% a year. More important, it’s been very effective at reducing risk. In 2008, for instance, when the stock market declined 37%, a 60/40 portfolio would have dropped just 17%. This wasn’t an isolated case. The 60/40 approach has come through for investors in other times of economic stress, including the Great Depression.

So why is the 60/40 approach suddenly under attack? In my view, this stems from the dramatic growth of index funds. In recent years, investors have been fleeing actively managed funds—that is, funds run by traditional stock-pickers—and opting for passively managed funds. The fund performance data indicate this embrace of indexing is a smart move—and not just for ordinary investors. A simple 60/40 mix of stock and bond index funds has delivered better results than most university endowments, including Ivy League schools.

For many years, it’s been awfully hard for anyone to top the humble 60/40 mix, especially when it’s implemented with a set of low-cost index funds. But this trend doesn’t serve the interests of Wall Street brokers. Because index funds pursue a largely buy-and-hold strategy, they don’t generate nearly the volume of trading commissions that active strategies do—and hence it’s no great surprise to see Wall Street analysts taking aim at the tried-and-true 60/40. They would like nothing better than to shake investors loose from these simple investments.

I don’t want to dismiss these analysts out of hand, just because they might be biased. It’s important to understand their arguments. While each of the brokers’ views varied, they all focused on the same key concern: Bonds, they argued, are expensive. One broker went as far as to say they’re in a bubble. But this is where their arguments get shaky.

There’s no question that bonds are expensive. Yields on U.S. Treasurys are just 1.5% to 2.3%. The question is, how best to respond? The brokers’ prescription was to move money out of government bonds, and instead buy corporate bonds and emerging markets bonds—investments that carry far more risk. They also recommend that investors buy more stocks as an alternative to bonds, favoring companies that pay larger dividends.

This is a dangerous argument. No matter how you look at it, the diversification benefit of government bonds has been strong in virtually every time period. The analysts argue that this benefit could break down. But if you look at historical data, it’s hard to make that case. More important, government bonds offer investors a guarantee that stocks never will: that folks will receive their principal back. I see it as extremely unhelpful to suggest that investors move out of government bonds, and into stocks or into riskier bonds.

That said, there’s nothing magical about the specific percentages in the 60/40 mix. What’s important is to build a portfolio of stocks and bonds that’s the best fit for you. That means a portfolio that accounts for your household’s financial goals, as well as your objective capacity to take risk and your personal tolerance for risk.

That might end up being 60/40, but it might just as easily be 40/60, 80/20 or some other combination. What’s universal, however, is the importance of keeping things simple and maintaining a mix of stocks and government bonds. As much as Wall Street would prefer that you opt for something more exotic—and more lucrative for them—I would resist the temptation.

Adam M. Grossman’s previous articles include Got You CoveredAn Unkind Act and The REIT Stuff. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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Axel1005
Axel1005
1 year ago

Recently I have been trying to get yield of about 5 % in these tough times for income.

I’m
struggling iwth this article by Left Banker on CEFs in Seeking Alpha.
Is there anything about CEF (closed end funds) income funds on this site ?

https://seekingalpha.com/article/4325129-strategy-for-sustainable-inflation-adjusted-7-income

All the best, and thanks.

Michael1
Michael1
1 year ago

This reminds me of Jonathan replying to a question of mine some time ago saying that in his own portfolio, he prefers to play it safe with bonds while taking whatever risk he chooses in his equities (I hope I paraphrased that appropriately). That and the advice in this article make good sense to me.

booch221
booch221
1 year ago

So your bond portfolio must be exclusively in US government bonds?

Vanguard has me in the Total Bond Market Fund (VBTLX) which is a mix of 70% government and 30% corporate bonds and includes some foreign bonds.

Roboticus Aquarius
Roboticus Aquarius
1 year ago

The 60/40 will never die. The US centric version may lose out to an internationally diversified 3 fund portfolio for a while, and vice versa… but it will always provide a solid long-run return.

dl777
dl777
3 months ago

My understanding is that when interest rates go up (as they have to as current high inflation is finally acknowledged), intermediate and long term bond funds will act like equities and lose a significant amount of principal (Fidelity estimates a 27% principal loss on 10 year bonds if rates go up by 3%%). Since short term government bonds are only offering .18% 30-day yield, where else can one go to at least keep up with 2+% inflation (I think it is way higher than this actually) without risking principal. (money markets are only .4-.5% currently also. Thanks for your article.

Jonathan Clements
Jonathan Clements
3 months ago
Reply to  dl777

At this juncture, I don’t think you can expect after-inflation gains from high-quality bonds. Instead, you need to own stocks if that’s your goal. So why own bonds? They’re a source of spending money when stocks are suffering, a way to mellow out a stock portfolio’s volatility and a source of rebalancing money when stocks are in a bear market. But you can’t count on bonds any more for a decent yield — unless you buy very risky bonds, at which point you might as well own stocks.

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