Investing

The 60/40 portfolio has powered retirements for decades. With 60% stocks and 40% bonds, this balanced fund offers equity-fueled growth and fixed income stability.

Today, however, many are calling into question the sustainability of the 60/40 portfolio. Some even argue that it’s dead and that retirees need take on more risk if they want to avoid outliving their retirement savings.

In this article we’ll take a deep dive into the 60/40 portfolio and whether it’s still a viable approach to investing for retirees.

A Brief History of the 60/40 Portfolio

Dating back to 1926, the 60/40 portfolio has enjoyed an annualized return of 9.1% (Source: Vanguard). Its best year, 1993, saw returns of 36.7%, while its worst year, 1931, experienced a loss of 26.6%. Over those 95 years, 22 saw the portfolio decline in value. The returns combined with relative stability have made the balanced portfolio ideal for retirees.

More recent returns show similar results. From 1972 to 2021 a 60/40 portfolio consisting of an S&P 500 index for stocks and intermediate term Treasuries for bonds has returned 9.61% with a standard deviation of 9.51% (via Portfolio Visualizer). The combination of solid returns with less volatility has been ideal for retirees.

In his 1994 paper, certified financial planner Bill Bengen gave us what is now known as the 4% Rule. In brief, the 4% Rule states the following:

• A retiree can spend 4% of their investments in the first year of retirement;
• In subsequent years, the retiree can adjust the prior year’s distribution by the rate of inflation; and
• Following this approach, the retiree should not outlive their money.

Why do we care about the 4% rule? We care because the 60/40 portfolio fits in the sweet spot of the 4% Rule. Bengen found that retirees should hold somewhere between 50% and 75% in equities. In a later book, he identified 60/40 as the ideal portfolio in retirement to avoid outliving a nest egg. Other papers evaluating safe withdrawal rates have reached similar conclusions (as we’ll see in a minute). Some have even evaluated its performance back to 1871!

Notwithstanding the 60/40 portfolio’s stellar history dating back to the post-Civil War era, many are now calling into question its future.

Arguments that 60/40 Portfolio is Dead

There have been several arguments put forth that the 60/40 portfolio is no longer ideal for retirees. All of the arguments stem from the unprecedented financial times we are currently in.

Argument #1: Bond yields are at all-time lows

The yield on the 10-year Treasury sunk to its lowest in 2020 and remains at historic lows. When viewed on a yearly basis, the yield sunk below 2% back in 1941 (1.95% to be precise). Apart from that one year, it remained above 2.00% until 2012 (Source: Shiller). It’s currently at about 1.30%.

During much of the 20th century, the yield was significantly higher. It reached over 14% in 1982. At today’s low yields, many question how a 60/40 portfolio could survive a 30-year retirement.

From Money (4/21/21):

“I think the 60/40 portfolio is antiquated,” says Keith Singer of Singer Wealth Advisors in Boca Raton, Florida. “When bonds used to pay 6-8% and interest rates were falling, the 60/40 model worked great. But as they say, past performance is no guarantee of future results, and that is especially true with the 60/40 portfolio.” (Source: Money).

Argument #2: The 40-Year Bull Market in Bonds Is Over

The second argument relates to the fall of yields over the past 40 years. They hit a high in 1982, and then steadily dropped to their historic lows today. As bond yields fall, the value of existing bonds go up. As such, retirees have benefited from falling interest rates. Unless rates go negative, however, most believe the bull market in bonds is over

If the bond bull market is over, and rates begin to rise, the value of existing bonds will fall. Rising rates can also lead to lower asset values on everything from stocks to real estate, which brings us to the third argument.

Argument #3: Equity Valuations are High (and must fall significantly)

Many point to the richly valued S&P 500. The Shiller PE, which measures price-to-earnings over 10-year periods, is at one of its highest levels.

The argument here is simple. Lofty valuations suggest that stock returns over the next decade will be much lower than historical averages.

At the same time, many argue that the 60/40 portfolio should shift to a greater allocation in stocks. The reason is that while stocks are expensive, the additional long-term returns are needed to offset the paltry returns expected from bonds.

A recent report from Goldman Sachs framed the issue as follows:

The beneficial role of bonds in balanced portfolios has more recently been in doubt given that bond yields close to the zero lower bound offer a diminished returns buffer during “risk-off” periods. These doubts have only increased alongside concerns that an accelerating economic recovery from the pandemic-induced recession, amplified by historically large US fiscal stimulus, could lead to a strong rise in inflation and, in turn, the start of a prolonged bond bear market. During most historical bond bear markets, equities have outperformed bonds and have delivered positive real returns. This has been especially the case over the last 20 years, during which bond bear markets tended to be short and shallow.

Source: https://www.goldmansachs.com/insights/pages/gs-research/reflation-risk/report.pdf

Argument #4: Negative Correlation May be Over

Finally, many believe the negative correlation that stocks and bonds have enjoyed over the past two decades may be over. In a report entitled The End of 60/40, Bank of America analysts warn that bonds may no longer provide the diversification investors have come to expect.

The authors explain,

The core premise of every 60/40 portfolio is that bonds can hedge against risks to growth and equities can hedge against inflation; their returns are negatively correlated,” Woodard and Harris added. “But this assumption was only true over the past two decades and was mostly false over the prior 65 years. The big risk is that the correlation could flip, and now the longest period of negative correlation in history is coming to an end as policy makers jolt markets with attempts to boost growth.

In short, there’s no place to hide.

Arguments that 60/40 Portfolio is Still Solid

All of the above arguments identify real and significant challenges to the capital markets. Interest rates are at historic yields. The 40-year bull market in bonds does appear to be over. And stock valuations are extremely high.

Nevertheless, I believe the 60/40 portfolio is still ideal for retirees. It’s not the only reasonably allocation in retirement, but it will continue to support a retiree for 30 years or more who relies on the 4% Rule. Here’s why I believe this.

Argument #1: Retirees are long-term investors

Those who retire at a traditional age are long-term investors. For a 65-year-old couple, there is a 1-in-4 chance of at least one spouse living past 97 and a 1-in-10 chance of at least one spouse living to 100 (Source: BofA). Retirees could be in the market 35 years or longer. To put that number in perspective, 35 years ago Ronald Reagan was President and Boy George and Mr. T were filing an episode of The A-Team.

The point is that while both equities and bonds may underperform over the next several years, or decade, retirees must consider a much longer time horizon.

Of course, the first ten to 15 years of retirement are critical. Due to the sequence of returns and inflation risk, a devastating market in the first decade of retirement could spell disaster. And that brings us to the second point.

Argument #2: The 60/40 Portfolio has Worked Since 1871

No, that’s not a typo. Researchers have tested the 60/40 portfolio against the 4% Rule with markets dating back to just after the Civil War. It’s never failed.

Michael Kitces, CFP, published a paper showing the maximum initial withdrawal rate one could have taken in the first year of retirement without running out of money over a 30-year retirement. His research tested retirements beginning in 1871.

The lowest initial withdrawal rate was 4.4% in 1966. Some years could have seen an initial withdrawal rate of over 10%. The point is that a 60/40 portfolio has sustained a 30-year retirement through the aftermath of the Civil War, the Panic of 1893, WWI, the Great Depression, WWII, the stagflation of the 1970s, the tech bubble, 9/11, the Great Recession, and the ongoing Covid pandemic.

Argument #3: The 60/40 portfolio offers growth and stability

When compared to a portfolio heavily weighted in stocks, the 60/40 portfolio stands out for its excellent growth and muted volatility. That’s not to say it’s not volatile, but its up and downs are significantly less than a 100% stock portfolio. And that’s precisely what many retirees need.

Since 1972, a 60/40 portfolio has returned an annual compound rate of 9.61%. These returns are lower than a 100% stock portfolio, which returned 10.75% over the same period. What’s notable, however, is the volatility. The standard deviation of a 60/40 portfolio was just 9.51%, while the stock portfolio came in at 15.25%.

To put these differences in perspective, the worst year for a 100% stock portfolio during this period was -37.45%, compared to just -16.88% of the 60/40 portfolio. At the same time, the worst maximum drawdown for the stock portfolio was nearly -51%, compared to -28% for the balanced portfolio.

The increased volatility that comes with 100% stocks brings us to the next argument.

Argument #4: Retirees can stick with a 60/40 portfolio

Studies have shown that investors are not adept at timing the market. Called the investor gap, studies have documented the gap between an investment’s return and an investor’s return. Because investors tend to buy high when stocks are rising and to sell low in a panic when investments fall, they consistently underperform the very investments where they place their money.

One Morningstar study found that investors lost on average 45 basis points due to market timing. There was, however, one bright spot. The study found that investors in less volatile investments performed better. From the study,

When we broke down funds within asset classes based on their standard deviation, we found that funds in the least-volatile quintiles consistently had higher investor returns than those in more-volatile quintiles. This suggests that “boring” funds work well because they aren’t as likely to inspire fear or greed.

A portfolio with more stocks may perform better over the long-term. Investors in retirement, however, need to ask whether they can handle the ride.

Argument #5: The 60/40 portfolio survived rising rates and inflation

No two time periods are identical. Today we face challenges the U.S. and world have never faced. We can, however, look back at similar times to gain an understanding of how the 60/40 portfolio might perform when interest rates and inflation rise. Here I’m thinking of the period from 1941 to 1982.

The yield on the 10-year Treasury stood at 1.95% at the start of 1941. In 1982 it began the year north of 14%. Over the decade leading up to 1982, the U.S. experienced double-digit inflation, with low growth, giving way to the term stagflation.

During this time how did the 60/40 portfolio perform for retirees? Just fine. To be sure, this period is why we have the 4% rule. It represents the low water mark on a safe initial withdrawal rate. But that rate still stands at 4 to 4.5%.

The 60/40 portfolio also performed well more recently when rates began to rise earlier this year. The first quarter of 2021 was the worst for U.S. investment-grade bonds in the last two decades. The 60/40 portfolio did just fine:

“The first quarter of 2021 showed that even the worst quarter for U.S. investment-grade bonds in the last 20 years wasn’t enough to derail the classic 60/40 portfolio”, says Jason Kephart.

So what’s the take for investors. As long as the correlation between traditional asset classes doesn’t shift dramatically and the portfolio continues to rise over time, then holding a 60/40 portfolio still makes sense.

That doesn’t mean investors shouldn’t consider some alternative mixes but perhaps hold those on the margins and keep your core in stocks and bonds. Although, instead of holding broad indexes, they might want to consider diversifying by adding buckets of individual stocks and bonds.

At the end of the day, the most important risk any investor should always think about is the permanent loss of capital and the loss of purchasing power. The 60/40 portfolio still offers the best defence. And even it if did seem to veer off course at one point, it could have been by design.

Source: https://www.morningstar.ca/ca/news/213154/does-the-60%2F40-portfolio-still-make-sense.aspx

Building a 60/40 Portfolio

So far we haven’t discussed the stock and bond investments that make up a 60/40 portfolio. Most of the studies on a balanced portfolio use an S&P 500 index for stocks and intermediate term U.S. bond fund for fixed income. Given current economic challenges faced by retirees, should we further diversify our asset classes?

Warren Buffett would likely say no. The Warren Buffett portfolio he recommends consists of just two asset classes: S&P 500 index and short term U.S. government bonds. He’s bullish on the future of the United States.

At the same time, the U.S. faces significant hurdles. Its population is aging, reducing the workforce while increasing the cost of social programs for senior citizens. The country’s debt to GDP ratio skyrocketed as a result of the pandemic and now stands at more than 125% (Source: The Fed). And our politicians in Washington seem willing to continue borrowing at unprecedented levels indefinitely. Eventually we’ll have to pay for all of this spending.

As a result, some financial advisors recommend moving beyond U.S. stocks and Treasuries. Bob Rice, the Chief Investment Strategist for Tangent Capital made such an argument when he spoke at the fifth annual Investment News conference for alternative investments.

“You cannot invest in one future anymore; you have to invest in multiple futures,” Rice said. “The things that drove 60/40 portfolios to work are broken. The old 60/40 portfolio did the things that clients wanted, but those two asset classes alone cannot provide that anymore. It was convenient, it was easy, and it’s over. We don’t trust stocks and bonds completely to do the job of providing income, growth, inflation protection, and downside protection anymore.”

Source: https://www.investopedia.com/articles/financial-advisors/011916/why-6040-portfolio-no-longer-good-enough.asp

While I don’t share his pessimistic views of the 60/40 portfolio, diversifying to international equities seems reasonable. This could include both developed countries and emerging markets. Other diversification opportunities could include real estate (REITs) and commodities. For bonds, some argue that retirees should take on more credit risk through high-yield bonds and emerging market debt.

Having said that, there’s no guarantee that diversifying the portfolio will lead to better results. A well diversified portfolio has significantly underperformed a basic 60/40 portfolio over the last 15 years (commodities data wasn’t available before 2007 in Portfolio Visualizer).

At the same time, if we remove commodities and add the 5% allocation back into the S&P 500, we extended the data to 1999 AND see that the greater diversification paid off.

Of course, this time period saw the tech bubble burst, 9/11 and the Great Recession, all of which had significant affects on the S&P 500. And that really is the point. While diversification is generally a sound approach to investing, it’s not a guarantee of higher returns.

Final Thoughts

The 60/40 portfolio is certainly not the only reasonable approach to investing in retirement. Yet for many retirees, it has stood the test of time. It offers both growth and stability, which retirees need for their money to last 30 years or more.

Nobody knows the future. Is it possible that we could see unprecedented economic conditions that could wreck havoc on retirees? Of course we could. Although if that happens, one wonders if any asset allocation would save us.

It costs money to invest. We pay all types of fees, some obvious, some not so obvious. In this article I’m going to walk through the most common investing fees you are likely to encounter. Then we’ll examine just how destructive a seemingly small amount of fees can be to your wealth and retirement.

Do Fees Really Matter?

Before looking at specific types of investment fees, let’s first ask whether fees really matter. To answer that question, the first thing we must recognize is that seemingly small fees, over time, can seriously reduce the value of an investment portfolio.

The Securities and Exchange Commission (SEC) published a paper on this very topic in 2014. It noted that “fees may seem small, but over time they can have a major impact on your investment portfolio.”

Some have argued that fees don’t matter. Instead, what matters are returns after factoring in the fees. In other words, paying high fees is not only fine, but ideal, if the investment returns enough to justify the fees. Conceptually this makes sense. In practice, however, it falls apart.

Study after study after study shows that expensive investments underperform inexpensive investments. For example, Vanguard looked at the annualized returns for a 10 year period ending December 31, 2014 for two groups of mutual funds: 25% of the funds with the lowest expense ratio and 25% with the highest. The low-cost funds won.

The primary way we keep fees down, as we’ll discuss more below, is to use low-cost index ETFs and mutual funds. It’s an approach Warren Buffett, the CEO of Berkshire Hathaway and arguable the best investor alive today, supports:

Nevertheless, both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit. So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm.

My money, I should add, is where my mouth is: What I advise here is essentially identical to certain instructions I’ve laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife’s benefit. . . . My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.

Types of Investment Fees

There are countless fees investors may encounter. I’m going to list them in the order you are more likely to encounter them. Some fees are virtually unavoidable, but can be kept to a minimum. Other fees should be avoided at virtually all costs. Frankly, the only fee that is truly unavoidable is the first one on our list–expense ratio.

Expense Ratio

Mutual funds and ETFs charge investors a fee. The fee covers the cost of the fund, including payroll, as well as profit for the fund company. Expense ratios are expressed as a percentage. For example, a fund that charges a one percent (1%) expense ratio would cost an investor 1% of the amount invested in the fund (e.g., $100,000 investment would cost $1,000 per year with a 1% expense ratio).

The expense ratio is practically unavoidable. Fidelity does offer a few funds with no expense ratio, but that’s the exception. Even low-cost fund provider Vanguard charges expense ratios on its ETFs and mutual funds.

Transaction Costs

There can be costs to buy and sell stocks, mutual funds and ETFs. By and large these costs are easy to avoid. Most mutual fund companies and brokers have gone to $0 trades if made online. There is, however, one important exception.

Many brokers charge a commission when you purchase a mutual fund (not an ETF). For example, I have an account at Merrill Edge, and the broker charges $19.95 when I purchase certain mutual funds. They do have a list of fee-free funds, but many of the funds I use from Vanguard would require payment of the commission.

For this reason, it’s important to understand the types of investments you want to make before choosing a broker. If you know, for example, that you’ll invest entirely in Vanguard funds, it makes sense to open an account at Vanguard or a broker that offers at a minimum free Vanguard ETFs. M1 Finance is a good example and a broker I also use.

Investment Advisor Fees

Advisor fees come in two forms: (1) a percentage of assets under management (AUM), or (2) a fixed or hourly fee. The vast majority of advisors charge a percentage of AUM, with 1% the industry standard (although fees do vary based on account size and services provided).

Some lower cost AUM advisors have entered the market over the past 10 years or so. Vanguard offers advisory services for just 30 basis points. A number of so called robo-advisors offer their services for about 25 basis points (e.g., Betterment and Wealthfront).

A growing list of advisors have turned to hourly or fixed fees. These arrangements almost always favor the client, as the total cost is generally far less than the AUM model. One such advisor is Mark Zoril of PlanVision.

As you’ll see in a minute, Advisor fees based on a percentage of AUM destroy more wealth than any other fee (although high expense ratios are a close second).

Load Fees

Some mutual funds charge what are called load fees. Front-end load fees are paid when you invest in a mutual fund with this type of fee; Back-end load fees when you sell.

Front-end load fees typically cost 5.75%. For every $100 invested, fees take $5.75, leaving $94.25 in your account. There’s absolutely no reason to invest in mutual funds that charge load fees. Ever!

Where to Find the Expense Ratio of a Mutual Fund

There are several easy ways to find the expense ratio of any mutual fund or ETF. For starts, you can Google the ticker symbol of the fund. VSTAX, for example, is Vanguards total stock market fund. Searching “VSTAX” returns the following result, including the fund’s expense ratio:

You can also see if a fund charges a load fee AGTHX, an American Funds growth fund:

Another free tool that tracks both the expense ratio as well as any load fees is Morningstar. You can also check the prospectus of the funed.

As for investment advisor fees, you should ask. It’s as simple as that. It should also be reflected on your statements. You can also find fee disclosures in the advisor’s Form ADV. But asking is much easier.

How to Determine the Expense Ratio of Your Investment Portfolio

While it’s important to know the expense ratio of each investment, what really matters is the overall expense ratio of your portfolio. You could calculate this by hand. Just take the weighted average of your expense ratios across all of your investments. If that sounds as inviting as a root canal, there is an easier way. Use Personal Capital.

Personal Capital is a free financial dashboard. Link all your financial accounts (checking, savings, credit cards, retirement accounts, HSAs, loans, taxable investments) and Personal Capital provides a wealth of tools. You can do everything from budgeting to loan payoff to retirement planning. And for our purposes, it will automatically calculate the expense ratio of your investment portfolio.

Here’s the results from a demo portfolio I entered into Personal Capital:

Note the 0.10% annual fee to the right. That’s the expense ratio of a portfolio that included dozens of investments. You can read my review of Personal Capital or go directly to its free signup page (truly free-no credit card needed–ever).

How Fees Affect Your Wealth

Let’s imagine that we make the maximum contribution to an IRA ($6,000) during our working years from age 20 to 65. If we earn an average of a 9% return on our investments, we’ll retire with about $3.1 million (gotta love compounding).

Now let’s assume we pay an investment advisor a “small” 1% fee. Our retirement fund drops to $2.3 million. Add in a 1% expense ratio on the mutual funds, and our nest egg falls further to $1.7 million. Yeah, fees matter.

How to Avoid Most Investment Fees

There are several important steps to take to keep you fees low.

Low cost index funds: First, stick to low cost index funds (ETFs or mutual funds). They outperform the vast majority of actively managed funds over time. There are plenty of sound “lazy portfolios” that make for great long-term investment strategies. Here are a few of them:

• 3-Fund Portfolio
• Warren Buffett Portfolio
• Paul Merriman Portfolio
• Ray Dalio Portfolio

Avoid Expensive Advisors: There’s simply no good reason to pay more than about 0.30% of AUM, at the most. Vanguard offers its services at this price. Why pay more? And there are plenty of advisors who charged by the hour, which is even better.

Consider Automated Investment Services: For those that want a little help, you can consider a robo advisor. They come in all shapes and sizes. I like Betterment and Wealthfront for those who want a set-it-and-forget-it arrangement. Cost is about 25 basis points. For those who want more control, M1 Finance is the way to go. It lets you create your own mutual fund (they call them Pies). It’s easy to use, easy to rebalance, and free.