The Problem With The 60/40 Portfolio

If your money is invested with a financial adviser, there is a good chance that it’s deployed in some variation of the 60/40 portfolio. That has been the conventional approach for decades. Unfortunately, the results for such a portfolio in the current environment are likely to be unattractive and might not meet your financial goals.

The 60/40 portfolio refers to one that has approximately 60% in stocks and 40% in bonds. Some financial advisers tinker with that asset allocation and move it around in a range, perhaps between 40% stocks and 70% stocks. The goal, according to conventional wisdom, is to provide a good level of long-term returns with a smoother ride that won’t scare the clients too much, nor cause them to be a forced seller at low prices during stock market sell-offs.

Sounds great, right? If you are at or near retirement, and you meet with a well-dressed financial adviser showing you that historically his 60/40 portfolio has produced solid returns with moderate risk, there is a good chance you will sign up. They will give you posh service, offer you nice refreshments and push across the table a “customized” financial plan print-out which will demonstrate to you that if history were to repeat itself you will comfortably meet all of your financial objectives. All that is left is for you to sign on the dotted line, and hand over your assets to them, for a very “small” fee.

Not so fast. Let’s do a reality check on this very common pitch and see how well it holds up under objective scrutiny.

What typically goes in to the bond portion of the portfolio? It’s either U.S. government bonds or very high-grade corporate bonds. At the time of this writing, the 30-year U.S. government bond is yielding 1.41%. That compares to approximately a 5% average yield over the last 30 years, and to an 8% yield 30 years ago. High-grade corporate bonds are not yielding much more than the government bonds, with the spread between A-rated bonds and the government bonds at approximately 1.2%. The extra yield from these corporate bonds is no free lunch, as although very safe, some small percent of these bonds will default over a 30 year time frame.

A typical financial adviser will either buy index funds, large mutual funds that are likely to do almost as well as the index funds, or blue-chip stocks. Why is the focus only on large, well-known companies? Is it because they are the most undervalued? Because they are likely to produce the highest, market-beating returns?

No. There are two reasons. The first is a business reason. Your financial advisor is unlikely to be blamed too much if they had mediocre results investing in large companies. These are household names, and you, their client, know these companies and think of them quite favorably. On the other hand, if they were to try to invest in some small, undiscovered company and then do poorly, they are afraid that you will blame them and take your business elsewhere.

The second reason is that your typical adviser is not really equipped to search for great, unknown investment opportunities. A lot of their time is spent on business development and client service. Few among them have the investment process necessary to deeply assess and value potential bargains. Building a portfolio from such undervalued opportunities is no easy task. So they stick to the companies they know well themselves, the blue chips, whether they are undervalued or not. They think they will get a good return from them and that they are safe. However, just because a company is large or well-known does not mean that its stock is a good or safe investment. 20 years ago GE was one of those blue chips that was owned in almost all portfolios. How well did that work out so far?

In your meeting with your financial adviser, you are likely to be told how U.S. equities have returned 9% to 10% per year over the long-term. Implicitly is the promise (with, of course, the usual fine-print disclaimers) that that is in the neighborhood of what you can expect to make going forward. But is it?

Investment returns over the next few decades are likely to be much lower than over the last century. Why? Because the underlying starting conditions are different:

• Inflation is the amount that the purchasing power of money is reduced each year or put another way, the percentage that prices of goods and services rise each year. One way to measure the market’s inflation expectations is the difference between the regular U.S. government bonds and the inflation-protected government bonds (TIPS) of the same maturity. Currently, inflation expectations are less than half of the rate of inflation experienced over the last century.
• Real GDP Growth is the amount that the economy grows adjusted for inflation. The last couple of decades we have experienced growth of around 2%, which is lower than that seen over the last century. That makes sense, since we are a much more mature economy, and is still a very good outcome in both a historical context and compared to other mature economies such as Europe and Japan.
• The Dividend Yield, or the dividends paid divided by the stock price, is much lower than it has been over the last century.
• The current starting Valuation, as measured by the Price-to-Earnings (P/E) ratio for the S&P 500 is approximately 21x, compared to around 15x over the last century.

So if you are buying a representative basket of large U.S. stocks today, you should expect lower growth in earnings, lower dividend yield and a decline in the P/E ratio over 30 years. The estimate in the preceding table might shock you, but I genuinely believe it is what one can reasonably expect from a broad basket of stocks from the current starting point. Feel free to disagree or tinker with the individual assumptions – you are still likely to reach the conclusion that future stock returns are going to be far below the long-term history of around 10% that you are frequently told is what stocks are “supposed to” produce.

If you combine low expected returns for both stocks and bonds, this is what you can expect from the 60/40 portfolio:

That’s not all. Your financial adviser didn’t get his nice house and fancy car by working for you for free. He is likely to charge you a “small” fee of between 0.5% and 1%, for his services. When returns are high, such a fee has a relatively smaller impact on your long-term results. However, in a low-return investment environment that we find ourselves in today, that fee takes a very large bite out of your likely already meager annual returns:

So what is the problem with the 60/40 portfolio approach that is supposed to provide good returns with moderate volatility? That in the current investment environment, it is not actually likely to provide good returns over your investment horizon. And if the above estimates prove to be even approximately right, are you likely to meet your retirement or other financial objectives with such an approach?

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An earlier version of this article was published on the Behavioral Value Investor