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As a new, green investor climbs the rungs of investment education, it’s won’t be long before they encounter the 60/40 portfolio. 60% stocks, 40% bonds. Tried and true and old as time…or, at least, that’s how it’s presented to us.
But where did the 60/40 come from?
Why those percentages? Why’s it good for retirement?
In a world where we can prescribe an asset allocation specifically for a unique family’s financial circumstances, why do we keep on discussing this 60/40 portfolio?
The Birth of 60/40
The 60/40 traces its roots back to Harry Markowitz and “modern portfolio theory” (MPT).
MPT is a big reason why we’re here. Markowitz won a Nobel Prize for this work, discovering that diversification truly was a “free lunch” in investing. Perhaps the only free lunch. By properly diversifying your assets, you can maintain satisfactory returns while decreasing the portfolio’s volatility.
This ratio of “returns divided by volatility” is important. It’s often referred to as “risk-adjusted returns.” We know that if we take more risk, we should receive more returns. But is that always the case? “Risk-adjusted returns” attempt to level the play field, allowing you to compare across many different assets.
There are a couple good ways to visualize these risk-adjusted returns.
One is via the “efficient frontier,” which shows a set of optimal investment portfolios offering the highest expected return for a defined level of risk. Or, written another way, the lowest risk for a given level of expected return. The efficient frontier contains only risky assets.
Another is the “capital market line.” It’s similar to the efficient frontier, but it adds in risk-free assets to the mix. It represents the most efficient, risk-adjusted portfolios combining a risk-free asset with a market portfolio.
If we plot the CML on the efficient frontier (like the graph above) specifically for stock/bond portfolios, we find a “tangency portfolio”** somewhere between 50/50 and 70/30.
**Tangent = where a line just barely touches a curve.
This “tangency portfolio” is, according to Modern Portfolio Theory, the mathmatical optimum mix of these specific assets.
This is the birth of the 60/40 portfolio. It has been, historically speaking, the most efficient bang-for-your-risk-taking-buck. It’s the best way to mix stocks and bonds if your goal is get the best ratio of returns vs. volatility.
Why 60/40 Makes Sense
We’ve established that the wonky, nerdy math suggests that the 60/40 portfolio makes sense. But, unintentionally, it’s also a great portfolio allocation for retirees.
From an asset-liability matching perspective, the 60/40 portfolio is great. 40% of the portfolio is in bonds. If we work backward from safe withdrawal rates (4%, 5%, whatever your preference), you’d find that ~40% in bonds might represent 8-10 years of retirement spending. That happens to be a terrific buffer against sequence of returns risk.
60/40 is also a terrific behavioral portfolio. Most people don’t care about the efficient frontier or Sharpe ratios. But they do know they phrase “don’t put all your eggs in one basket.” The 60/40 portfolio scratches that itch.
We’re going to be optimistic about long-term growth with 60% of your assets. We’re going to be cautious and conservative with 40% of your assets. We expect some “ebb and flow” to occur over time (“lack of correlation”), which is good for you as an investor.
It allows investors to participate in the bull markets while providing ballast during the bear markets.
I’m not saying the 60/40 is perfect. But it checks many boxes for the average investor.
60/40 and the 4% Rule
As I already alluded to, the 60/40 portfolio also plays very nicely with retirement safe withdrawal rates, like the 4% rule. The 4% rule was originally constructed assuming a 50/50 portfolio…not too far away from the 60/40 mix.
We can rewrite “4%” as “25x.” As in – you need 25x your annual withdrawal amount when you start retirement. [1 / 4% = 25]
What was I thinking? What a hideous graph…
The 60/40 portfolio, then, can be thought of as 10 years of bonds + 15** years of stocks. I know we want a portfolio of assets to behave in concert, and its not always smart to parse out the assets like this. But follow me for a second.
The 10 years of bonds buy us time. The first 10 years of retirement can, if needed, be funded with low volatility, dependable bonds. This time can be important for two reasons:
- On the pessimistic side, these 10 years without touching stocks can help us avoid sequence of returns risk. The most potent sequence of returns risk occurs in years 1-6 of retirement, tailing off quickly by year 10.
- On the optimistc side, these 10 years without touching stocks allows compounding to occur. The “15 years” of stocks that we started retirement with could easily double in value over those first 10 years. Suddenly, our entire remaining lifespan seems to be entirely funded.
Downside protection + upside potential.
That’s a potent mix.
What About *Other* Assets?
Invariably, the 60/40 portfolio gets accused of being too boring, too vanilla, too much “white shirt + blue jeans.”
That’s fair. To wit:
- The 60/40 portfolio isn’t a law of nature. It’s a historically convenient blend of growth assets and income-producing ballast. Seasons change, and so can our thoughts on the 60/40.
- Stocks and bonds might be more correlated than we once thought. See: 2022. 60/40 works best when bonds rally during equity drawdowns. That relationship is not guaranteed.
- Adding assets is about diversifying the underlying economics. The goal isn’t to “beat 60/40” every year. We want to hold assets that behave differently across inflationary, deflationary, growth, and recessionary environments.
Some common assets that investors add (and some commentary on them) include…
- Real Assets (REITs, commodities, infrastructure). Real assets tend to provide respond well to inflation and real economic activity – risks that bonds struggle with.
- TIPS. Inflation-protected bonds, as the name implies, address inflation risk more directly than nominal bonds.
- Alternatives. The wide, wide, wide world of “alternatives.” Tread carefully here. Done well, alternatives can provide genuine non-correlation to stocks and bonds. Sometimes, though, alts are prohibitively expensive. Other times, the alts are “putting lipstick on a pig” (it’s still a pig under there). Other times, the “non-correlation” is a simple accounting trick. If you’re only marking-to-market once a quarter, of course you’ll look much more stable that stocks and bonds being marked-to-market every day.
Hi Ho Silver!
Further Reading & Summary
Here are some other great posts on the 60/40 portfolio:
I’m convinced there are thousands of ways to get investing “wrong,” but also many ways to get investing “right.” Many portfolios are “good enough.”
Can we move from “good enough” to “perfect!” ?? I’m convinced we’ll only know that in hindsight. So, I think your best bet is to find something that’s “good enough” for your situation, that you can stick with through thick and thin.
The 60/40 remains an excellent candidate for exactly that.
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