R.I.P. 60-40 Portfolio

Jared Woodard is head of the Research Investment Committee at BofA Securities.

What is the 60-40 portfolio, and why has it been the go-to model for many investors? In a 60-40 portfolio, 60% of assets are invested in stocks and 40% in bonds—often government bonds. The reason it has been popular over the years is that traditionally, in a bear market, the government bond portion of a portfolio has functioned as insurance by providing income to cushion stock losses. In addition, bonds tend to rise in price as stock prices fall.

Why do you say that the 60-40 portfolio is dead? The problem is that as yields on bonds head lower and lower—the 10-year Treasury note pays 0.7% per year—there’s less return in fixed-income securities for buy-and-hold investors. So that insurance works less well over time. Plus, the prospect of government policies to boost economic growth increases the risk of inflation. Treasuries could become more risky as interest rates start to rise and prices, which move in the opposite direction, fall.

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But don’t bonds limit volatility in your portfolio? Bonds can become very volatile. Look back at 2013, after the Federal Reserve said it would reduce purchases of Treasuries and mortgage-backed securities. There was a period of incredible volatility for bonds—known as the taper tantrum—as investors adjusted. Our argument is that as the prospects increase for more government intervention in the markets to support economic growth, the risk goes up that Treasuries will become a source of volatility.

What’s a better portfolio allocation now? There are two parts to that question. First, who is the investor? Older investors with specific income needs may find that their overall allocation to fixed income might not need to change much—but the kind of fixed income investments they own might need to be very different. Younger investors might find that they can tolerate the volatility of the stock market over the course of an entire investing career, given the difference in return from stocks over bonds.

And the second part? That’s the economic outlook. If we were at the end of an expansion, it would make sense to be more cautious. But we’re coming out of a recession, and prospects for corporate earnings and economic growth are much higher next year. At the start of a business cycle and new bull market, being too cautious means you miss out on the full returns of that cycle.

What fixed-income holdings do you prefer now, and why? Think in terms of sources of risk. Treasury bonds won’t default, but inflation and higher interest rates are big risks. Other bonds yield more, but they have credit risk, or the risk of not being paid back in full. Our contention is that the fixed-income portion of your portfolio should feature more credit and stock market risk and less interest rate risk.

We think the credit risk is worth taking in corporate bonds rated triple B, or even in higher-rated slices of the high-yield market. We also like preferred stocks and convertible bonds, which have characteristics of both stocks and bonds. These four categories can yield 2.5% to 4.5% today. Real estate investment trusts that invest in mortgages yield about 8% and pose less risk than REITs investing in commercial real estate. Finally, some 80% or more of S&P 500 companies pay dividends that are higher than the yield of 10-year Treasuries.