By Dan Hallett on February 25, 2020
There have been many large proclamations in the investing world over the years. Perhaps the most famous – or infamous – is Business Week’s August 13, 1979 magazine cover declaring “The Death of Equities”. Others emerged during the late 1990s’ euphoria surrounding technology stocks – e.g., that Warren Buffett was no longer relevant in the supposed “new paradigm” of investing. For the past several years, I have heard repeated claims that good old-fashioned bonds are, well, passé. Similarly, that portfolios built with 60% stocks and 40% bonds – i.e. 60/40 – are dead. While less dramatic, these more recent statements are still striking.
I began hearing advisors pooh-poohing bonds years ago. But in a recent interview with CNBC, Jeremy Siegel – Wharton finance professor and author of Stocks for the Long Run – said that 60/40 just doesn’t cut it anymore. His reasoning is simply that bond yields are so low that you need more exposure to growth-oriented assets – i.e. stocks – to deliver the returns of the 60/40 of decades past. His solution is 75/25; or 75% stocks and 25% bonds. Generally speaking; Dr. Siegel is correct but that doesn’t mean investors should run out and blindly follow this advice. First, some historical perspective.
An investor who – on December 31, 2004 – invested in a portfolio consisting of 20% Canadian stocks, 40% global stocks, and 40% in Canadian bonds – and held on through December 2019 – would have seen an average compounded rate of return of about 6% per year. (Note that these returns are not pure index returns but returns for a portfolio of exchange traded funds.) It’s likely that a mix closer to 75/25 – as suggested by Dr. Siegel – will be needed to deliver a return of 6% per year for the next 10 to 15 years. No argument there; but that doesn’t mean the idea of the balanced portfolio should be cast aside.
I expect the 60/40 asset mix to deliver a rate of return that exceeds guaranteed alternatives by 2 to 3 percentage points per year. (See this older blog to better understand how we calculate future return expectations.) That level of extra return is consistent with the past. The challenge is that the guaranteed-alternative hurdle has been very low for more than a decade. For instance, some of the highest GIC rates for 1- and 5- year terms are 2% to 2.5% per year. What Dr. Siegel is suggesting, however, misses two key points that impact ultimate investor success.
Nobody can reliably predict what markets will do in the short term. Accordingly, how an investor divides her assets across stocks, bonds, and other investments must be a function of longer-term needs. That means spending the time to create a real financial plan. Only then can you translate objectives into goals; and further translate that into a target rate of return. Not until that is done can it be determined what asset mix will meet an investor’s needs. The traditional 60/40 mix will surely meet fewer investors’ needs than in the past. But it’s far from dead and will continue to meet the needs of many.
The other challenge pertains to investor behaviour. My past research suggests that investors experience higher returns with less volatile investments; even when the latter offer lower returns. I’m referring to the difference between product returns and investor returns. Longer holding periods generally equate to higher investor returns. When investing in more volatile investments; investors’ trades are more frequent and more ill-timed. Accordingly, a less volatile investment will equate to higher investor returns because investors will hold it longer and be less likely to be lured into poorly-timed trades. While I’m convinced that a 75/25 portfolio will have a higher return than 60/40; I’m equally convinced that many investors are unlikely to enjoy those higher returns because of how they’re likely to behave with a more aggressive portfolio.
So be careful about following general advice. It may or may not apply to you. And even if it might, that advice must be evaluated in the context of each investor’s situation before determining if it makes sense.