The 60/40 portfolio is a classic investment portfolio consisting of 60% equities and 40% fixed income. If you are within five years of retirement or are in retirement, a 60/40 portfolio is a common recommendation.
Thanks to a low or negative correlation between stocks and bonds, soon-to-be retirees or retirees have been encouraged to hold a good amount of bonds to reduce volatility and risk compared to an all-stock portfolio.
As someone who is currently focused on de-risking his portfolio before re-retiring once there is herd immunity, I’m considering a 60/40 asset allocation to help protect my gains. Stocks are expensive and we’ve been in a nice bull run since 2009.
I don’t want to lose my gains since the pandemic began. At the same time, I still want to benefit from any further upside.
My rollover IRA, for example, was 100% equities, 0% fixed income for the past 5+ years. I used equity structured notes to help dampen the portfolio’s volatility and offset some of the downside risk. That said, it was still essentially 100% equities.
Recently, however, I rebalanced the portfolio to 93% equities, 7% bonds. But I need to do more.
Let’s review the benefits of a 60/40 portfolio and discuss why adding other alternative investments may make sense.
The Benefits Of A 60/40 Portfolio
Here are three main benefits of a 60/40 portfolio.
1) Solid Historical Returns
Since 1987, the 60/40 portfolio has posted annualized returns of roughly 9.16%. In the last 10 years, the portfolio achieved a 9.76% compound annual return, with an 8.45% standard deviation. This is in spite of ever-falling interest rates since the late 1980s.
A substitute for the 60/40 portfolio is the Vanguard Balanced Index Fund, VBINX. You can also construct a 60/40 portfolio using VTI for equities and BND for bonds.
Note: depending on how you construct the 60/40 portfolio, I’ve seen the historical annualized returns are anywhere from about 7.6% – 9.16%.
2) Lower Volatility
While the 100% equity portfolio holder was having a heart attack in March 2020 when the S&P 500 crashed 32%, the 60/40 portfolio owner was likely feeling better with his portfolio down only ~22% from peak to trough.
As someone who hates volatility, a 60/40 portfolio would help improve my mood and my happiness during another market correction. When you are retired, your goal is to try and think the least as possible about your money.
3) Higher income with a 60/40 portfolio
The final key benefit of a 60/40 portfolio is higher income. Depending on how you structure your equity holdings, you will be able to receive dividend payments.
If you invest entirely in growth stocks, you will likely not receive any dividend payments as retained earnings get reinvested into the company. However, if you invest in the S&P 500 or dividend aristocrat companies, you should be able to earn at least a 1.5% dividend yield.
The bond portion of your portfolio will then provide steady coupon payments (interest payments) as well. You could either own bond funds, individual bonds, or a combination of both.
In 2020, a 60/40 portfolio produced a 2.04% dividend yield, which was more than 3X the average 10-year bond yield that year.
As a retiree looking to live mainly off passive investment income, a 60/40 portfolio helps you better achieve this goal than an all-stock portfolio.
The Rise Of The 60/40 Portfolio
For many years now, many pundits have claimed the 60/40 portfolio was dead. They thought the secular bull market for bonds was over. But as we know, interest rates kept coming down and bonds kept going up. As a result, the 60/40 portfolio continued to perform well through 2020.
However, now that interest rates have risen, the attractiveness of a 60/40 portfolio should be higher. Based on the returns chart above, a 60/40 portfolio increased by only 2.47% YTD 1Q2021 compared to a 6.17% increase in the S&P 500 during the same period. Given the huge decline in bonds, the underperformance of a 60/40 portfolio is to be expected.
However, as an investor, we must be forward-looking.
When the 10-year bond yield was at 0.51% in August 2020, the yield was not attractive enough for me to buy bonds. I didn’t think we were heading into deflation, which would be the main reason why bond prices would keep rising and yields would keep falling.
But with the 10-year bond yield around 1.9% today, bonds are relatively more attractive. Bond yields have been rising because inflation is high and the Fed has signaled it will be raising rates.
With a correction in stocks and bonds, constructing a 60/40 portfolio is looking more attractive.
The 60/40 Portfolio Plus Alternatives
Since the 60/40 portfolio was first popularized decades ago, a lot of new asset classes have also become more available to the investing public. As we learned in a previous article on how the rich and endowment funds invest, a greater portion of a portfolio has been going towards alternative investments.
These alternative investments mostly consist of real estate, farmland, private equity, hedge funds, and commodities. Now cryptocurrency is becoming more popular, although much more volatile.
Below is a returns chart of various publicly traded assets and real assets from (1992 – 2020). What do you observe?
The asset with the highest mean return was Farmland at +11.01%. Farmland also had the second-lowest standard deviation of 6.9%, meaning it was the least volatile asset. Finally, farmland had the highest Sharpe ratio of 1.21, which means it had the highest risk-adjusted return.
Sharpe Ratio = (average rate of return on the investment – the risk-free rate of return) divided by the standard deviation of the investment.
US REITs Performance
US REITs had the second-highest returns with 9.86% annualized returns from 1992-2020. However, as mentioned in my post on how real estate gets impacted when stocks sell off, US REITs are often more volatile than stocks. With a Standard Deviation of 18.31%, US REITs have the highest amount of volatility.
During the March 2020 meltdown, US REITs melted down even more. Therefore, my observation in real-time back then was that if you want to smooth out volatility, US REITs are not the way. We now have more data to back up this claim.
Gold Is Not A Good Hedge
On a risk-adjusted basis, Gold is the worst asset class out of the six highlighted above. With an annualized return of 6.4% and a Standard Deviation of 14.91%, Gold has the second-worst returns with the highest volatility. Further, Gold produces no income.
Therefore, Gold is not a great addition to a 60/40 portfolio. It neither performs as well as US Stocks or hedges as well as US Bonds, Farmland, or US Real Estate. It seems like investors are slowly moving away from Gold and are replacing it with Crypto.
Finally, we get to US Bonds, where the returns are the lowest at 5.46%. However, the Standard Deviation for US Bonds is also the lowest at 4.55%. Therefore, US Bonds are an effective way of dampening volatility and providing a hedge in a 60/40 portfolio.
Farmland Outperforms During Recessions
We understand that spreading a portfolio across multiple uncorrelated asset classes reduces volatility and protects returns from exogenous shocks. Therefore, instead of just investing in Bonds in a 60/40 portfolio, perhaps investing in Farmland as part of the 40% is a good idea.
After all, Farmland has provided double the historical returns compared to US Bonds (11.01% vs. 5.46%) with only a slightly higher Standard Deviation (6.9% vs. 4.55%). Given the increasing scarcity of Farmland and increased food consumption, Farmland should continue to perform relatively well as an asset class.
Below is a chart that shows the NCREIF farmland index delivered positive returns every quarter in which the S&P 500 declined. For example, during the Global Financial Crisis when the S&P 500 declined by 46%, NCREIF actually went up 17%.
Alternative Investments For Diversification
For long-term investors interested in diversifying into alternative investments, US farmland may be an attractive option. Many individual investors are less familiar with farmland, thanks to historical high barriers to entry.
However, farmland is becoming increasingly accessible, thanks in part to technology-enabled platforms such as FarmTogether.
FarmTogether offers investors a single, easy-to-navigate platform for evaluating investment opportunities, reading diligence materials, signing legal documents and monitoring investments on an ongoing basis.
Further, FarmTogether doesn’t require the high investment minimums typical of other alternative investments. Accredited investors can get started for as little as $15,000.
The 60/40 portfolio should grow in popularity as interest rates rise and stocks become more volatile. I do recommend investors diversify into alternative assets such as farmland, real estate crowdfunding, and other real assets to reduce volatility.
Personally, I’ve invested $810,000 in real estate crowdfunding platforms like Fundrise and CrowdStreet to earn more passive income and take advantage of inflation. With inflation elevated, rents and property prices are rising. Further, I want to invest in the Sunbelt/Heartland thanks to positive demographic trends.
Readers, what are your thoughts on the classic 60/40 portfolio? Is it more attractive now that bond yields have risen? Instead of just having an investment portfolio consist of just stocks and bonds, what are your thoughts on adding alternative investments to hedge against stock volatility?