As the American economy resets, investors need to rethink basic assumptions. That’s difficult to do.
Some believe that history repeats. So, they want to stick with what worked in the past.
One popular idea shows the problem with refusing to change.
The “60/40 portfolio” is a staple of financial planning. It delivered strong gains for decades.
But history can’t repeat in this case. That makes the 60/40 portfolio dangerous.
The strategy consists of 60% stocks and 40% bonds. It offers possible gains from stocks, and it provides safety with low-risk bonds.
Over the past 20 years, the 60/40 portfolio has delivered average annual gains of about 7%. The S&P 500 Index gained an average of more than 8% over that time.
But the 60/40 portfolio reduced risk by more than 30%. Investors got 88% of the gains with 70% of the risk of stocks.
These qualities — stock-like returns and lower volatility — explain the popularity of the strategy.
However, this type of performance can’t be replicated in the future. That’s due to the relationship between bonds and interest rates.
The Rise and Fall of Bonds and Interest Rates
Bonds did well in the past because of the long-term decline in interest rates.
In 2000, the interest rate on the 10-year Treasury note was more than 6.5%. Last year, it fell below 1%.
10-Year Treasury Rate From 2002 to 2020
(Source: Federal Reserve.)
As interest rates rise, bond prices fall.
This relationship exists because once bonds are issued, they trade in the secondary market.
This provides liquidity for investors who might not want to hold the bonds to maturity. But it also means that old bonds must be priced competitively against newly issued bonds.
If new bonds are being issued at higher rates, then older bonds must drop in price so that investors can pay less and receive an amount of income equivalent to the new bonds.
With falling interest rates over the long term, Treasury notes delivered an average gain of about 6% in the futures market. This explains the past performance of the 60/40 portfolio.
The 60/40 Portfolio Is Now Dangerous to Investors
Now, rates are at 1%. It seems unlikely they can fall below zero.
It seems likely rates will rise, which means bonds will lose money. By one estimate, bonds will decline 8.5% if interest rates rise 1%.
Over 20 years, if interest rates rise 5% — mirroring their decline over the past 20 years — then bonds will lose about half their value.
With bonds positioned to drag performance on the 60/40 portfolio down over the next few decades, investors need to look for a new approach.
Increasing the allocation to stocks increases risks. Yet, there is no alternative.
Investors need to follow the advice of investing legend Warren Buffett and put all their eggs in one basket — stocks — and watch that basket closely.
As the economy reboots, investors can no longer afford to ignore their portfolios. They need to actively manage investments in the next few decades.
Michael Carr, CMT, CFTe
Editor, One Trade