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Destroying The 60/40 Portfolio Myth

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Investing is simple, right?  Just put 60% of your portfolio in stocks and 40% in bonds and go live your life.

10 or 20 years later, you will be in great shape.  Recessions and bear markets will interrupt the progress from time to time, but they won’t change the ultimate outcome…financial success!

OK, now let’s remove ourselves from this dream sequence and return to reality.  Not the version of reality that Wall Street is convincing investors is in the bag for them.  60/40 portfolios, while often effective, are just not the cinch they are portrayed to be.  And like so many investment market myths before it, that of the 60/40 being a stone cold, lead pipe lock needs to be brought into the light for what it is: an overrated, over-simplified attempt to make a sale based merely on what has happened in the recent past.

Now, the explanation.  Here is the history of 10, 15 and 20 year returns of the S&P 500 Index.  These are “rolling” returns, which means I have plotted those returns over the 10-year periods ended each month since 1970.  Same with the 15 and 20-year variety.

My key findings in this history:

10-year annualized rolling returns

  • The median return was 6.3%
  • The returns ranged from 16.8% to -5.1%
  • One-quarter of the time, the return was below 3%
  • About 10% of the time, the return was negative

These facts do not strike me as a compelling case for a long-term investment in the S&P 500 Index, though that is the assumption that so many investors are making.  But with the S&P’s 10-year annualized return at a gaudy 13.5% through March 31 of this year, a level rarely exceeded other than the latter part of the Dot-Com Bubble era, it is understandable that investor psychology is more greedy than fearful today.  But as I see it, a “long-term investment” period such as 10 years is far less certain than investors make it out to be.

Now, you may point out that this discussion has only covered 60% of that 60/40 portfolio.  After all, the 40% is in bonds, and bonds historically have produced nice returns when stocks have not.  However, this is where the case for typical 60/40 portfolio going forward falls especially flat.

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With bond rates near generational lows, the potential for bonds to make up for a likely lower long-term stock market return going forward is weak.  After all, the 10-year U.S. Treasury Bond yield is not 6% or 8% or higher, as it was at the precipice of past stock bear markets.  It is well under 3% as of this writing.  That means that even if we had that average 6.3% return on stocks for the next 10 years, and bond returns came in at around 3% (which in itself could be a stretch), that produces about a 5% prospective return for a 60/40 portfolio.  That is sufficient for many retirees and pre-retirees.  But it will take a herculean effort on the part of global financial indexes to produce that kind of return.

Do not mistake anything I am saying here as gloomy.  I do believe that the next 10 years and beyond will be a time of great wealth creation potential for investors.  I just don’t think it will be done in a way that resembles the past.  Markets have changed too much and returns from the future have been pulled forward to the present for the most popular investment strategies like S&P 500 Indexing and 60/40 portfolios.  The next decade and beyond will be about applying a more tactical discipline, a willingness to bypass a heavy emphasis on bonds in the portfolio, and an understanding of how to profit from extended down periods in both the stock and bond markets.  In the environment I envision and expect for the next 10-20 years, 60/40 portfolios will be as mobile as a scarecrow.

Speaking of 20-year periods, I did look at the history of those as well.  In fact, there was not a negative 20-year period in the history of the S&P 500, which dates back to the 1950s.  The lowest annualized return was 2.4%, and the median was 6.8%.

The last 20 years (ended 3/31/19) have produced just a 4% annualized return for the S&P 500.  That tells us how much a recession or two can knock down the long-term return potential that makes the 60/40 fantasy work for those marketing it.  But once we factor in the reality that business cycles are real, and that there is not some new era of permanent prosperity, the 60/40 portfolio looks more like a sales pitch based on the recency effect than something to dedicate 10 or 20 years of your prime investing years to.

My intention is to help you to have what every investor must have to be successful: a healthy skepticism of conventional wisdom when it comes to what works in long-term investing.  If this brief review of market history and the odds of achieving certain return levels helped you to keep from simply putting your portfolio on auto-pilot, then we have accomplished something important.

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