Challenging the 60/40 Asset Allocation

The financial industry is fond of dictates, and “following the herd” is a common theme in behavioral finance. In the early 2000s (a few years after I opened my financial planning firm), the industry changed a “balanced” portfolio from 50% equities and 50% fixed income to a 60/40 mix. The 60/40 portfolio was crowned as “balanced,” and it is still widely used in the industry today.

The firms that maintain statistics justify the 60/40 allocation by stating it is the combination of equities and fixed income that has provided good long-term historical returns. It provides cushion if the stock market decides to plummet, or if bonds decide to misbehave, as they have in recent years. It provides adequate exposure to equities when they are performing well. Fair enough. But it is not appropriate for everyone. Because no one can predict the future, every investor should ponder what is best for them.

There is a fascinating story about Harry Markowitz—a legend in the financial industry for his theories on risk and return and “Modern Portfolio Theory.” He earned a Nobel prize in economics in 1990.

Jason Zweig, in his book "Your Money and Your Brain," tells the story:

In the 1950’s, a young researcher at the RAND Corporation was pondering how much of his retirement fund to allocate to stocks and how much to bonds. An expert in linear programming, he knew that “I should have computed the historical co-variances of the asset classes and drawn an efficient frontier. Instead, I visualized my grief if the stock market went way up and I wasn’t in it, or if it went way down and I was completely in it. My intention was to minimize my future regret. So, I split my contributions 50/50 between bonds and equities.”

Why would Harry Markowitz set aside theories and statistical analysis when working with his own portfolio? One would assume that his rational thinking (his prefrontal cortex) was dominant due to the fact that he was an economist who spent his career analyzing financial statistics. Yet he realized that measuring risk and return was only a part of the solution. The bigger issue was recognizing that human behavior (and the way we respond to stock market fluctuations) cannot be predicted or controlled by theories and statistics. This emotional reaction to stock market swings originates in the amygdala, and Markowitz understood how powerful this emotional behavior can be. In this sense, he was way ahead of his time.

The above story is an excerpt from my first book The Joy of Financial Security, Chapter Two on Neuroscience and Financial Decisions (available everywhere books are sold). I am currently writing another book titled Becoming Enriched: The Radical Next Step to Improving Your Life and Your Finances.

How do I use the wisdom in Markowitz’ story?

First, I don’t accept that a 60/40 asset allocation is appropriate for everyone. I am now retired from serving clients, so I can only share how I currently manage my own family’s investments. I am aware of the concept of “sequence of returns risk” which warns that the return during the first few years after retirement are the most important for a retiree’s portfolio, and that is a time to not be overly aggressive. I keep my family’s investment accounts at an allocation of roughly 45-50% equities and 50-55% fixed income. I converted most of our bond funds during 2023 to bond ladders, locking in attractive yields of 4.75-5.0+ percent for treasuries and CDs for many years. That felt like a great opportunity to safe-guard the fixed income portion of the portfolio. Equities seem way overpriced (in September 2024), but I do not try to predict the future.

How can you use Markowitz’ story with your clients if you are a financial advisor?

Have a heartfelt conversation with them, informing them that an emotional reaction to a significant market downturn is common. Recognizing that no one can predict future investment returns, discuss what they believe is an appropriate asset allocation. It may not be 60/40.

What if you are an individual investor?

Talk with your partner, and discuss how comfortable you are with risk. How much of your investment portfolio would you be willing to lose in a significant downturn? The S&P 500 declined 54% during the 2008 financial crisis, and a 60/40 portfolio at that time declined roughly 32% or less. (The bond portion performed well). I would not sleep well if my family’s retirement nest egg lost a third of its value, so I choose to be more conservative. I’ve always been fond of turtles, and the adage “slow and steady wins the race” helps me sleep well at night.