Why Risk 40/20/40 When You Can Recreate Your 60/40? by Steve Abramowitz

Do you rebalance your retirement portfolio?  Many studies have shown that you should. The folks at Hartford Funds compared the results of a 70/30 buy-and-hold strategy with annual rebalancing of an $100,000 lump sum investment from 1999 through 2023. The asset manager found that the rebalanced portfolio produced a nest egg over $13,000 greater than simple buy-and-hold.

But rebalancing does much more than just improve performance. It encourages you to sell high and then buy low, reestablish your original position, lessen volatility, return to your preferred level of risk tolerance and increase diversification.

If rebalancing qualifies as the Holy Grail, then why limit the method to reconfiguring the venerable 60/40 stock/bond allocation? Say you think a certain sector of your stock fund is horribly overvalued. You could reduce the imbalance by selling it (or some of it) and replacing it with a fund having a less lopsided profile.

The Case for Rebalancing

Now, if you’re a devout Bogelhead, you’ll probably see where I’m going with this post as blasphemous. But at least hear me out. Market observers far better informed than me have expressed concern about the stark overrepresentation of technology stocks in the S&P 500. Writing for the highly-respected Reuters news agency in July, Ankika Bismas noted that the gap in returns between the S&P and its equal-weighted counterpart is at the widest in fifteen years, underscoring the wisdom of diversifying beyond heavyweights like Nvidia. She warns that the one-third weighting in mostly mammoth AI-linked technology companies makes the broad market index vulnerable to a sharp retrenchment.

I’d like to propose Vanguard’s Dividend Appreciation Index Fund (VDADX) as a sensible alternative to the technology-glutted Vanguard 500 Index Fund (VFIAX). Nonsense, you cry, its .08 cost is double what you’re paying now. True, but the difference between the 1.7% dividend of the suggested replacement fund versus the 1.3% yield of its predecessor more than compensates for the 0.04% expense gap between them.

The Vanguard 500 Index Fund

Before we introduce Dividend Appreciation, let’s review some basics pertaining to Vanguard’s S&P proxy. Once a large-blend fund according to Morningstar’s investment Style Box, the Vanguard 500’s holdings now fall disproportionately into the large-growth space due to its current 33% weighting in technology companies. Is that where readers intended or want their “broad market” exposure to be?

Seven of the top ten stocks in the Vanguard 500 are mammoth AI-fueled tech stocks and those ten account for 36% of the fund’s net assets. The median market cap is a daunting 274 billion. Because of its tech overweight, the fund is surprisingly aggressive, losing more than 18% in the 2022 rout. As you can tell, today’s version of the S&P 500 is more growthy, less diversified and riskier than many folks realize.

The Vanguard Dividend Appreciation Index Fund

Now, let’s compare this picture with the corresponding data for Dividend Appreciation, which is more robust than its name would suggest. Although the fund has maintained its large-blend style designation, the technology sector comprises fully one-quarter of the fund’s net assets. Importantly, the suggested substitute fund is a dividend growth vehicle and not a more stodgy high-yielder whose contents would have landed it in the large-value box.

Only three of Vanguard Appreciation’s top ten holdings are technology companies and those ten constitute less than a third of net assets. Notably, 30% of the fund is invested in the more defensive health care, consumer products and utilities sectors, about 10% more than in the Vanguard S&P surrogate. Plus, the median market cap of the replacement fund is under 200 billion, only two-thirds of the size of companies in the Vanguard 500. Significantly, Dividend Appreciation lost only 10% during the 2022 debacle. Taken together, we’ve learned that the fund is more balanced in style, better diversified and more stable than its predecessor.

The New 40/20/40 Allocation

Many people who believe they are comfortably ensconced in a 60/40 retirement plan are actually sailing in an unsteady 40/20/40, with the middle 20% consisting almost entirely of AI-fueled technology behemoths. Readers approaching retirement or just wading in are highly vulnerable to an unfavorable sequence of returns. Is 40/20/40 where you should or want to be?

I want to anticipate a reasonable rejoinder to my presentation. The relative performance of the two retirement vehicles has been entirely dismissed. Frankly, I didn’t think that conversation was necessary—we all know that in recent years a higher tech overweight has translated into a higher return. Hence, $10,000 put in the Vanguard 500 ten years ago would now be worth about $35,000, as against the $30,000 that would have resulted from the same investment in Dividend Appreciation. Presumably, most of that discrepancy is due to the funds’ different representation of technology stocks.

Some last notes.The dividend growth fund tracks about 85% of the changes in the broad market index. If an investor wants to increase the sensitivity of his retirement portfolio using Dividend Appreciation in place of the Vanguard 500, he could raise the stock fund’s allocation from 60% toward 65%.

I have viewed diversification in terms of what the lay of the land “should be” based on the logic of the past—technology exposure “should be,” say, about 20%. But who are we to disagree with the voice of the market, which is calling out that technology companies legitimately reflect one-third of the entire market’s value? It may be that AI and its beneficiaries are the real deal, or perhaps we are foreshadowing a reenactment of the dotcom bubble dressed in the regalia of a new era.