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60-40 Portfolio Won't Prepare Investors for Retirement

60-40 Portfolio Won't Prepare Investors for Retirement
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By Tuesday, 15 September 2020 05:59 PM Current | Bio | Archive

The 60/40 allocation, consisting 60% equities, 40% fixed income, is a standard asset allocation in many retirement plans. Risk parity funds are essentially a leveraged version of the 60/40 portfolio.

This portfolio and slight modifications of it have performed remarkably well in recent years. However, market history shows this is unlikely to work as well as the macroeconomic environment changes. Indeed the 60/40 portfolio might be the riskiest allocation option for investors hoping to retire in the coming decades.

Interest Rates

In the U.S., rates have generally trended downwards for the past 40 years, boosting valuations for both equities and fixed income. Over 90% of the price appreciation for the standard 60/40 portfolio over the past 90 years occurred between 1984 and 2007. With rates at near zero, the tailwind that supported fixed income is gone. It’s unlikely the next four decades will be like the last four decades.

The 60/40 portfolio works poorly during time periods where interest rates stay at or near the zero bound. During the 1990s, Japanese retirees attempting to live off a 60/40 portfolio allocation with domestic assets would have run out of money as the central bank kept rates low attempting to stimulate the economy. In the U.S. during the 1930s great depression interest rates stayed near then historically low levels, and the 60/40 portfolio experienced a 78% drawdown.

The current setup leaves few investors prepared for a macro regime shift that is likely imminent.

Macro Regime Shifts

Recent research from Deutsche Bank asserts that a major structural change in the global economy is about to occur, ending the prior era of globalization that lasted from 1980-2020, and entering a new era of disorder. Paul McCulley, a former managing director and chief economist at Pacific Investment Management Co, has also argued we are “unambiguously on the cusp of a major change in the economy. He also stated that if 60/40 works over the next four decades, democracy has failed. This is relevant because macro regime shifts can upend a traditional 60/40 portfolio.

In the late 1960s pressures built up in the Bretton Woods system until it broke in 1971, untethering the dollar from gold, and creating a purely fiat monetary system. During the high inflation 1970s, investors experienced large real losses in both stocks and bonds.

Equities suffered a brutal bear market, and bonds were known as “certificates of confiscation” because their nominal yields couldn’t keep up with inflation rate. The 60/40 portfolio provided no diversification or protection. In the coming era, the situation might be worse. Since risk parity funds are highly leveraged, their unwinding could create a feedback loop amplifying any drawdowns.

Diversification Illusion

Investors often naively assume that a balanced mix of stocks and bonds will provide a natural diversification during times of turmoil. Yet, contrary to popular belief, the 60/40 portfolio doesn’t provide adequate diversification. According to research by Artemis Capital, since 1880, stocks and bonds have had a positive correlation for often they’ve had a negative correlation. Indeed, there have been multiple periods where stocks and bonds both declined at the same time. Examples include, the 1970s, the late 1950s, the 1940s, and from 1906-1909. Few financial advisors working today have ever experienced any of these periods.

Alternatives to 60/40

So, what can investors do? Unfortunately, there isn’t an easy answer. Diversifying internationally can help avoid overexposure to the arguably overvalued U.S. market.

However, finding truly non-correlated sources of risk and return requires going beyond traditional stock and bond allocations.

To truly diversify a portfolio for the long term, investors need to maintain an alternative investment allocation. Funds focused on commodities, precious metals, volatility, and global macro require heightened due diligence up front, but are likely to be essential in the long term. Strategies that seem risky might be the only way to protect against the risk of doing the same thing for the next 40 years.

Jacob Mohs is CEO of BLX Global, which develops and licenses innovative financial products and created the Earnings Indexes, tracking earnings performance of FAANG, airlines and banking stocks.

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The 60/40 allocation, consisting 60% equities, 40% fixed income, is a standard asset allocation in many retirement plans. Risk parity funds are essentially a leveraged version of the 60/40 portfolio.
portfolio, retirement, investors
Tuesday, 15 September 2020 05:59 PM
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