Early in my career, a fellow financial advisor had a book about how all the attempts at portfolio customization invariably pointed to the same basic asset mix of 60% stocks and 40% bonds. This mix was ideal for many – providing just enough growth to boost return potential, but enough safety to keep bear market losses at an acceptable level.
Over the past few years, much has been written about the death of the 60/40 portfolio. Although this asset mix meets the needs of fewer clients today, reports of its death have been exaggerated.
There was a time when clients expected double-digit returns, and advisors talked them down to 7%-8% per annum. But return targets should be the result of a robust discovery process, not an arbitrary number.
Your investment planning process should uncover the purpose of the money invested. Translating this into a measurable target will imply a particular asset mix.
Your risk-profiling efforts will, quite independently, point to some mix of stocks, bonds and cash. For many portfolios, this will point to a 60/40 asset mix or something close to that.
The highest return expectation I hear these days is usually 4%-5% a year. The hangover of two bear markets in the past 16 years and razor-thin yields in guaranteed investment certificates are likely factors in the reduced expectations.
Even these modest targets are no slam dunk – hence the reason for the advertised death of bonds and our old friend 60/40.
Stocks aren’t cheap, but they’re priced to deliver 7%-8% annually over the next several years.
Bond prices imply a future total return of about 2%-3% a year. For a 60/40 portfolio, that implies returns of 5%-6% per year – before fees. This falls to a net (before taxes) return of 3%-4%, depending on total costs.
This rate of return will meet the needs of many, but will fall short for a large contingent of investors. Although 60/40 isn’t what it used to be, it isn’t dead. When this asset mix is not enough to meet clients’ goals, you have a few options.
Increasing exposure to equities risk increases return potential – with an associated rise in volatility and downside risk. Even more than 50 years ago, Benjamin Graham recognized that most investors need some growth. So, he recommended that most engaged investors hold at least 25% in stocks, but no more than 75%.
Reducing expectations can sound harsh, but it isn’t always a terrible option. Consider, for example, the idea of working for an extra two years before retirement. This not only adds two years of additional savings and investment growth, but removes two years of withdrawals from the portfolio.
This kind of compromise isn’t for everybody, but it can be powerful in making a traditional asset mix work.
Finally, you can seek alternative investments to try to reduce volatility, cut risk and/or enhance returns. Unfortunately, this strategy often doesn’t work in practice.
Whether we’re talking about hedge funds or private-market offerings, quality (low) and cost (high) usually combine to make the return on these investments disappointing.
There are good reasons to avoid these offerings but it is an option that has worked well for our clients.
Don’t accept blanket statements such as “bonds are dead,” or “60/40 is so 20th-century.” Make your portfolio decisions based only on clients’ goals, asset-class fundamentals and common sense.
Dan Hallett, CFA, CFP, is vice president and principal with Oakville, Ont.-based HighView Financial Group, which designs portfolio solutions for affluent families and institutions.
© 2016 Investment Executive. All rights reserved.