For the last 20 years, it was the standard rule of thumb for financial advisors: Retail investors should invest their investment portfolios 60% in stocks and 40% in bonds. It was presumed to provide the best of all worlds, combining potential for growth with protection if stock prices fell. The guidance wasn’t just peddled by banks and financial advisors, either. Target-date funds, the popular default investment options in retirement savings accounts, typically invest young workers mostly in equity and gradually move them to a 60-40 split as they approach retirement.
But the finance industry is rethinking this advice, with some advisors calling the 60-40 split dead, and encouraging investors to consider riskier alternatives. The first shot fired was a report from Bank of America’s Jared Woodard and Derek Harris, who argued bonds no longer offer diversification, and over the longer term, bonds will be subject to more volatility. The 60-40 split, they argue, made sense in a world where stocks and bonds were negatively correlated. Because bond returns rose when stock prices fell, bonds served as a hedge against falling stock prices, and stock were a hedge against inflation.
“But this assumption was only true over the past two decades and was mostly false over the prior 65 years,” they write. “The big risk is that the correlation could flip, and now the longest period of negative correlation in history is coming to an end as policy makers jolt markets with attempts to boost growth.”
They suggest seeking more diversification in other assets, instead, recommending high-dividend stocks and riskier bonds, such as municipal debt and short-term, high yield (aka junk) bonds. JP Morgan is making a similar recommendations. The bank suggests other income generating assets, like real estate.
But if you thought 60-40 was the right allocation five years ago, it would be a mistake to write it off now. Investment strategies are meant to hold for many years, independent of current market conditions, and yet advice is usually based on short memories. The steady, rising stock market and low-interest rates of the last decade may start to feel normal, but markets can change quickly. Low-risk bonds may not be offering much return, but that return is still the safest option available.
Bank of America’s economists argue long-term bonds will become more volatile in the coming years, and they foresee more frequent recessions. But the bonds may be less volatile than stocks or the higher-yielding bonds in a down market. Real estate, munis, and high-yield bonds may return more, but historically they are much riskier. Stock prices can fall even more in a recession.
Even if long-duration, highly rated bonds are more volatile than short-term junk bonds, they may still be less risky. The purpose of safe bonds is not diversification, it is hedging—and there is a big difference between the two. A well-diversified portfolio is a portfolio with the right combination of different risky assets. Hedging, by contrast, is about risk management. It normally involves some investment in risky assets and some that are risk-free. What’s risk-free for retirees and households? It depends on their goals. If it is maintaining a certain level of wealth, then short-term bonds are a good hedge because their price is pretty stable.
But if retirees plan on spending their savings, long-term bonds are risk-free because can predictably finance spending for about 15 to 20 years, or however long retirement lasts. Longer-term bonds offer a stable retirement because the income they generate has a similar duration as the income people need in retirement—income financed by 401(k)s, IRAs, and other forms of saving. They are the best place to invest, even if bond prices become more volatile, because the value of retirement spending and the price of bonds move together with interest rates.
The problem is the safest bonds are offering very low returns, and so savers face a dilemma. They can save more or take more risk. While moving out of a 60-40 allocation is the riskier option, it may be necessary for some investors, but it is no free lunch. Even more diversification can’t reduce the risk of loss. Odds are there will be a recession in the next 10 years and big drop in risky asset prices. That may be a bigger problem for savers than persistent low yields.