Here’s one way to modernize your balanced portfolio
For many years, I have been the guy warning investors and financial advisors about the risk of 60/40 portfolios. That is not the same thing as saying they have not been successful in the past. They have. However, in investing, the most dangerous thing you can say is “it worked in the past, so it will work in the future.”To my astonishment, the financial advice industry seems to be content with telling investors that the 60/40 portfolio (where you invest 60% of your assets in stocks, 40% in bonds, and adjust back to those weights periodically) is going to live forever. Perhaps that will be the case. However, it pays to consider some simple adjustments to that approach, even if you are a committed 60/40-er.
In just the 2 charts below, I aim to take you from questioning the beloved 60/40 portfolio to a “mic-drop” moment on the subject. That is, I will show you that at the very least, the way you use bonds as the “40” in the 60/40 portfolio must change.Now, I tend to build balanced portfolios that are principally stocks and stock market hedges, with bonds in a lesser role. However, I know that most investors do not operate this way.
60/40 gets a slight makeover
So, I am not going to assume you will see the benefits of hedging, using options in your portfolio, and investing tactically instead of using a static asset mix, etc. It is not for everyone, and I write plenty of material on that.Here, I want to simply take that classic 60/40 portfolio and alert you to a subtle change that might just save you some grief in the years ahead.
Spare yourself the AGG-ravation
The vast majority of 60/40 portfolios I run across (and there are many) invest in bonds with a strong eye toward what is in the Barclays U.S. Aggregate Bond Index, or “Agg” (ETF symbol AGG tracks it). This is a mix of Treasury Securities and Higher-Quality Corporate Bonds of varying maturities. In the chart above, I show you the yield history of AGG since 2005, alongside that of SHY, which tracks U.S. Treasury Notes with maturities of just 1-3 years.Agg has been the “gold standard” for bond investors for years. However, nearly 40% of the Agg is now in bonds maturing at least 20 years from now. That implies significant interest rate risk.
Heads they win, tails you lose
Or, look at it this way: rates have fallen so much over the last few decades, the Agg is boxed in. Its yield is too low to make up for the potential for higher rates. And, if rates stay low, so does the return of the Agg. To summarize: much higher risk than reward potential going forward.The chart above shows this pretty clearly. You can get close to the yield of the Agg by investing in U.S. Treasuries that mature in 1-3 years. This was not at all the case a few years ago. It wasn’t even close. Short-term yields were practically zero. But not anymore.The type of bond portfolio represented by short-term U.S. Treasuries may not excite your 60/40 mix. However, it does tamp down the risk of having 40% of your portfolio fail to preserve your capital.That’s what is on the table over the next 5-10 years, as inflation pressures build following a decade of Central Banks suppressing it. And, even if conditions do not change at all from those currently in place, it does not seem worth it to stick 40% of your assets in a bond portfolio with similar reward to a simpler bond mix.
Don’t be shy about shifting your approach to bonds
Above you see the same comparison of AGG and SHY, except that I have only graphed the spread between their yields. That is, the extra yield advantage of AGG over SHY is as low as it has been since 2008. Add that to the long list of current market conditions that remind us of past crises.So, is there a good reason to continue to fill the 40% of your 60/40 portfolio the way you probably did in the past? I simply cannot find one. Now, if you tell me you are using more esoteric bonds in your 40%, such as non-U.S. and Emerging Market Bonds, High Yield Bonds, and the like, that’s another story. But there, you are courting other types of risk, instead of simply taking the more jacked-up yields that short-term U.S. Treasuries offer.
Do you feel lucky?
Again, these are not recommendations. They are observations to make you think twice, no three times, about where you take risk in portfolios. Are you taking risks that are worth it for the rewards you seek? Or, are you just doing what somebody told you was a good idea 10 years ago, and not questioning it because it has worked out…so far?Related: Looking For Last-Minute Tax Loss Harvesting Ideas? Here’s One