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Portfolio > Portfolio Construction

What the 60/40 Portfolio Debate Is Missing

By John Ruth

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What You Need to Know

  • A 60/40 allocation to stocks and bonds was not originally intended for investors in or near retirement, the author says.
  • Increasing stocks creates sequence of returns risk; relying on low-yielding bonds creates longevity risk.
  • The author proposes an alternative called Managed Risk Control.

There’s been a lot of commentary recently about the time-honored 60/40 portfolio being ripe for a rethink. We couldn’t agree more. But we believe that the conversations, and particularly the solutions being suggested, are headed in entirely the wrong direction.  On top of that, nobody seems to be asking if these proposals are serving clients well.

While we agree that low rates are likely here for a while and that they put new strains and new risks on the fixed income side of allocation models, the question we are asking is: What should be done to evolve the portfolio for this new zero interest rate policy world?

We take umbrage with the two primary solutions we’ve observed being advanced in the industry to address concerns with the 40 percent fixed income side of the classic 60/40 portfolio:

  1. Change the allocation to a 75/25 portfolio (75% equities and 25% fixed income).
  2. To keep equities at 60 percent but change the fixed income allocation to a barbell between cash and long dated bonds.

Both proposals miss solving the problem and introduce undue risk. We argue the 60/40 proxy and risk allocation models in general may need to be flipped on their head altogether.

How did we get here and what investors are likely to be impacted by this discussion?

A traditional investment profile questionnaire once matched a 60/40 portfolio to an investor with moderate risk tolerance and a medium time horizon to retirement (or event of need). That was the classic use case anyway. However, that’s no longer the case.

Today, the 60/40 portfolio is being used broadly as an accepted solution for those much closer to or even in retirement. Look no further than the industry’s leading target date funds and you’ll observe that the only thing being retired for certain is the old 30/70 stock to bond portfolio.

Today’s target date glide paths no longer glide to anything that once resembled a purer conservative approach. Today, some of the industry’s leading target date series feature 2025 funds that are predominantly ranging from 50/50 to 60/40 stock to bond portfolios.

The classic implementation of the 60/40 was previously used to accommodate those with approximately a 20-year time horizon. Now, the 60/40 proxy is the new 30/70 stock to bond “conservative”  go-to. This is especially evident in America’s default 401(k) solutions.

Don’t get us wrong, we understand why managers have been forced further out on the risk curve. Fixed income is tougher to manage and produces more underwhelming results than it did 50 years ago.  Again, to that end, we agree on the problem — but not on the solutions proposed.

Given most retirement assets are held by those nearing and entering retirement, the 60/40 portfolio has never impacted more assets or more investors. These same investors have never been more vulnerable to the emotional toils someone who has worked their entire life to amass adequate savings will understandably feel during times of market volatility.

By the way, the boomer retirees have good reason to feel shell-shocked. Remember the dot-com crash, the 2008 financial crisis or Covid 2020? Yes, the market came back — eventually.  And yes, we believe the market will, over the long term, keep marching up and to the right. The problem is, when we previously used the 60/40 portfolio as a recommendation, those investors had 20 years left. They could stomach the volatility and needed to, in order to achieve their goals.

However, introduce the expected market volatility of a 60/40 portfolio too near or into retirement, and you’ve introduced major sequence of return risk. On the opposite side of the coin, if you accept zero as a net return on bonds, you’re exposing your client to the real possibility that they’ll outlive their money (longevity risk).

So, the consensus question being raised about the 60/40 portfolio has to do with the 40% classic fixed income side of the equation. It goes like this … given the risks present in fixed income due to a zero-interest rate world, how should portfolios be constructed to provide adequate protection against outliving one’s money while limiting duration and credit risks that may be uniquely present in today’s bonds as a result of our new zero interest rate policy world?

Next, we’ll examine the two proposals we’ve observed as being the most popular ideas for revamping the 60/40 and we’ll explain why those miss the mark.

The 75/25 proposal introduces sequence of return risk

One convention suggests that we deal with low rates by introducing more equities, especially dividend payers to produce an overall mix of 75/25 stock to bond. Sure, some bonds are facing headwinds.  However, we think a 25 percent increase in direct stock exposure in this proposal introduces unnecessary market volatility — volatility that may lead to unnecessary sequence of return risk, depending on the investor’s age and event of need.  It also fails to understand the psyche of the investment customer. It’s never fun walking that client each time the market drops.

If we learned anything in the last year it is that the world can change quickly.  Even if your client has time on their side in terms of planning for retirement, they may need those funds sooner than expected if an emergency arises.  While retirement funds shouldn’t be the first place to go for an emergency, things happen out of our control.  A lost job, a global pandemic, any unforeseen can derail the best ‘Plan A.’

No matter a client’s age, we should assume that they would prefer the same amount of return for less risk if possible and so must be ever curious about seeking relatively safer solutions that can still maximize return without unnecessarily inserting sequence of return or bad timing risk into their portfolios.  The 75/25 proposal fails on those merits.

The barbell of bonds proposal assumes average carries no greater risk

The barbell argument suggests that managers should be weary of stretching for yield during a time when it is as hard to find as disinfecting wipes were in mid-2020. The cautionary statement is on point in our opinion. You can find yield in two ways: stretch for duration or reach down to lower quality. Both are problematic.

If you reach for duration, you won’t like what happens to the value of your bonds when interest rates rise. Remember, bonds carry an inverse relationship to price and yield. We think you’ll prefer to be on the shorter end of the yield curve to deal with a rising rate possibility.

If you reach down in quality, you’re increasing default risk. My office looks out toward an old Sears wing of a local mall. Sears isn’t there anymore. Defaults happen and you’d be well served to remember how the mighty Sears fell if you’re tempted to go down the quality ladder in search of higher yield.

So where is the barbell problem? Well, the problem is the proposed solution to the agreed-upon problem. The barbell proposal essentially says one should keep their 60/40 allocation of stock to bonds. However, the bond portion (the 40%) should hold cash and long-dated Treasuries. This creates a barbell of bonds — heavy on the ends of curve and not much in the middle. In so doing, the barbell proponents are striving for the mean. This proposal looks to average the duration and yield that the bond side of the 60/40 was able to produce in times of old.

This approach is too simplistic, and the yield problem is much more dynamic than a barbell approach can handle. I don’t care much for average anything and you still aren’t going to enjoy the duration bet on those long-dated bonds when rates rise. Also, cash isn’t an investment.  Clients don’t pay managers to strategically hold cash for long periods of time. So, in our opinion, the barbell proposal doesn’t hold much weight.

We believe there is a better way. It’s radically different. It is a simple, elegant, and best of all, a repeatable solution.

Flipping the formula, with a twist

A few weeks before the pandemic hit, we put into practice a new thesis to address the needed reset on allocation models in general. Current recommended solutions all suggest the introduction of more volatility into this customer’s portfolio. Any introduction of stocks — or an increase in their proportion — will produce an outcome that is less repeatable. And bonds are not, in and of themselves, the enemy — but there are areas of the bond curve that should be avoided.

We took an entirely new approach: Rather than pushing further in the same direction, we decided to flip the equation. The result showed our thesis working as designed in real time. We were able to protect significantly during the COVID downturn and participate in the V-shaped recovery that followed.

We call this approach Indexed Risk Control. We currently offer three strategies. The conservative one is benchmarked to 30/70, and the aggressive one is benchmarked to 80/20 strategies. However, here we’ll examine our moderate strategy which we benchmark to a 60/40 total return allocation for fair comparison to the 60/40 examples above.

Yes, even with the dismal, low interest rate bond market, we are advocating something more like a 20/80 ratio to replace the classic 60/40 allocation.

But there are some caveats.

For comparison on behalf of an investor with moderate risk appetite and to compare to the classic 60/40 portfolio, we are recommending a core (80 percent or higher) comprised of actively managed (not indexed bonds) with shorter to intermediate duration.

Even the short end of the bond curve will be affected by the inverse price relationship, but it’s much easier to trade a bond with a 30-day maturity than a 30-year maturity. Owning bonds at the shorter end of the curve, will allow you to rotate out of those positions sooner rather than later, helping to manage the downside risk that currently exists in investment portfolios.

On the stocks side, we move to a more passive approach, gaining one directional exposure to the opportunity to participate in equity market growth through a long-only call options strategy.

We guide our strategies with a quantitative framework that seeks repeatable protection without sacrificing growth. Using this methodology, we seek to smooth out max drawdown events, while participating in market upside opportunities.

The result should be a better experience for the investor and a more deeply thought-out solution for today’s zero interest rate headwinds, where investors have been forced further out on the risk curve.  Here, we allow investors to rethink the efficient frontier by moving down the risk curve without sacrificing upside potential.  Afterall, we believe investors desire less risk for the same amount of return.

To recap, our rethink of the 60/40 portfolio is as follows:

  1. A foundation of actively managed bonds, thoughtfully managed for duration and credit risk.
  2. Flipping the overall ratio to allocate one directional upside stock exposure as an overlay on top of a fixed income core for something closer to 80/20 bonds to equity linked participation, powered by long-only call options.
  3. We manage the strategies through a quantitative framework that seeks more repeatable outcomes focused on providing investors with a smoother experience.

The most important consideration for us was the customer experience on down days. We sought first to insulate retirement investors from downside risk. In addressing a low interest rate environment, we’re not fixated on yield, but protection. Our alpha generation is then expected to be predominately generated from the equity options overlay.

In our opinion, this is a more customer focused methodology for addressing risks that are always being weighed in portfolio creation; sequence of return risk and longevity risk.  Investors that have worked so hard for their money deserve a rethink to today’s popular group-think of the classic 60/40 portfolio and asset allocation models and glidepaths in general.

John Ruth is co-founder and CEO of Build Asset Management, an RIA focused on an approach to investing that encompasses both risk control and upside potential that financial advisors can take to their clients to confidently save for retirement. John can be reached at [email protected].

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