The rule of thumb for retirement portfolios has long been 60/40: 60 percent in stocks and 40 percent in bonds. That is supposed to be roughly the optimal combination of growth (fueled by the equities) and stability (provided by the bonds).
It’s not just an old wives’ tale. The mutual fund giant Vanguard went back and ran simple model portfolios based on the 60/40 rule and found that, since 1926, an investor with that allocation could have expected an 8.6 percent annual return, with losses in 21 out of 86 years. An all stock portfolio bumped up the returns somewhat, to 9.9 percent — but the volatility was greater, with losses in 25 of the years. An all bonds portfolio reduced the volatility, with losses in just 13 years, but the overall return dropped to an average of just 5.6 percent.
But that’s an argument about the past. The present and future landscapes are changing fast enough to make many advisors rethink that basic portfolio allocation. Some of the factors that are reshaping retirement portfolios:
Bond market crash. In the wake of the stock market crash of 2008-09 and the Federal Reserve’s subsequent policy of near-zero interest rates, the bond market has taken a serious bath in recent years. The Barclays Aggregate U.S. Bond Index was down 2.71 percent through July 12, which puts it on pace to have only its third losing year since 1976.
No one expects to derive the bulk of their income from the fixed-income side of the equation. But now many people’s bond portfolios are not even beating inflation. The bond portfolio, intended to provide stability, has turned into more of a drag on returns for many investors.
Globalization. The American investor now has access to a wide array of international investments, including both equities and debt. Many investment advisors have discovered that branching out into international markets can add diversification, reduce portfolio risk, and help to foster greater returns. International stocks tend to be riskier than domestic ones, allowing advisors to reduce the allocation to equities and increase it to bonds.
Alternative investments. The plain fact of the matter is that there are many other investment opportunities now, aside from stocks and bonds. Investors have access to exchange-traded funds invested in all sorts of things, hedge funds intended to spike overall returns, and long/short strategies that can reduce the volatility of an equity portfolio. Alternative investments are almost ubiquitous at this point. Only 4 percent of advisors say their clients have no money invested in alternatives, down from 17 percent in 2008.
Long/short strategies are similarly growing in usage. Nearly half of all institutional investors, or 45 percent, say they use long/short strategies in mutual funds; that’s up from 38 percent in 2010.
Obviously, these alternatives can offer the increased diversification that can bring down a portfolio’s volatility. They also have the potential returns of equities, if not higher. At the same time, they are complex and risky, and may not be appropriate for all clients’ retirement portfolios.
The Norway Model. One popular tweak to the traditional model comes from Norway, which has allocated its government pension fund — the largest pension fund in the world — into 60 percent stocks, 35 percent bonds and 5 percent real estate. The stock part of the portfolio is divided half and half between American equities and issues from around the world.
And it’s done quite well. From 2000 to 2012, while the American stock market was returning an average of just 2 percent per year, the Norway Model doubled that at 4 percent.
The New Allocation Model. Three students at Duke recently tackled the 60/40 question as part of a contest that was intended to come up with a new paradigm for retirement portfolios. The winning formula, announced earlier this year, is as follows:
- 43 percent in U.S. equities
- 30.3 percent in a Russell 2000 index fund
- 12.7 percent in a Russell 2000 mid-cap fund
- Nothing in international equities
- 32.1 percent to a TIPS (Treasury Inflation-Protected Securities) fund
- 24.9 percent to an aggregate bond fund
That allocation produced an average annual return of 9.7 percent, with less volatility than more traditional models. It’s only been back-tested, though, and hasn’t been used in any real-world portfolios as of yet.
But it does point up that there are many avenues to choose for the more proactive wealth manager who wants to get beyond the old 60/40 model. Consider that allocation as a starting point, then look for the options that best suit each particular client’s risk tolerance and income needs. There’s a whole wide world out there.
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