We are seeing quite a bit of investment opinion lately focused on the idea that the ubiquitous 60 / 40 asset allocation is “dead” or at least comatose in the current market environment. But what does that really mean and should you tweak your allocation if it is truly 60 / 40 ?
The 60 / 40 asset allocation refers to a split of investment portfolios between stocks and bonds with the majority going to stocks. Generally speaking, a 50 / 50 split would indicate a moderate, not too cold and not too hot stance. Most investors are focused on retirement down the road so a bit more risk for the potential for a bit more reward would make sense depending on your age, hence the 60 / 40. Those who can stomach a little more risk might go 70 / 30 and so on.
So why would the 60 / 40 balance come under such criticism now? The answer is probably in the direction most investors have been convinced things are headed. And that direction is up.
Interest rates? Up.
If both inflation and interest rates are headed up in a big way, the most likely direction for bond returns is down. That’s because of the nature of their return. In most cases, bonds pay fixed interest on what is basically a loan. So, if the price of things we consume is increasing that bond income stream is worth less over time in terms of purchasing power.
And we talked last month about the Fed’s blunt toolbox. If they have to raise rates to fight inflation, the bonds you bought last year are going to pale in comparison to the bonds you can buy this year with higher rates. So again, down go your fixed income values.
All very logical, so what should you do? If the bond part of the portfolio is going to be under pressure from this upward direction, shouldn’t we just go to a 100 / 0 allocation? While it’s true that stocks outperform bonds historically in periods of inflation, the ups and downs in stocks don’t go away. Many studies show volatility increases fairly significantly during inflationary periods and a 100 percent allocation to stocks would likely lead to a very bumpy ride.
Instead, it’s probably wiser to look at the diversification of the bonds themselves within the 60 / 40 allocation. Not all bonds are created equally and some will be much less sensitive to inflation and interest rates. Just like in the stock allocation, where we wouldn’t suggest putting all the assets in small caps or a single sector, having a good mix of different types of bonds can make a big difference.
And at the end of the day, nobody really knows how high inflation will go, how long it will last or how quickly and to what degree interest rates might rise. Better to stay diversified and be prepared for surprises.
If you have questions about your asset allocation, reach out. We are always happy to take a look.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
The companies presented here are for illustrative purposes only and are not to be viewed as an investment recommendation.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.