Note that this section of the website is not particularly active; I hope to publish about one personal finance article per month.

Sunday, December 21, 2014

Why 60/40?

One of the stronger "rules of thumb" for investing was to have a "60/40 Portfolio": holding 60% equities (stocks), and 40% bonds. This portfolio allocation is aimed at providing good long-term performance with acceptable risk. In this article, I explain why the 60/40 allocation is reasonable - the tilt towards equities should provide higher returns, but the allocation allows for considerable uncertainty in future investment returns.

Policy Portfolio Guideline

The 60/40 rule should be thought of as guiding your "policy portfolio": the benchmark allocation amongst three broad types of assets:
  1. equities;
  2. bonds;
  3. money markets (cash). 

The "volatility" of the asset classes decreases as you go down the list; the prices of equities typically move up and down more than bonds, whereas money market instruments prices are typically very stable.

I describe the role of a policy portfolio in this primer.  As a quick summary, the policy portfolio is a guideline for your portfolio structure that you follow based on your tolerance for risk.

Once you have decided upon your weightings for the policy portfolio, you will then want to subdivide the broad asset classes into more specific investments. For example, if you have a 60% allocation to equities, 30% could be equity funds for your home country, and the other 30% could be foreign funds. Some assets, like high yield bonds, act a bit like a hybrid of stocks and bonds, and might have to counted as such.

It is easier to classify how much risk you want to take when you take just these 3 asset classes. My feeling is that it is very difficult to grasp the aggregate risk profile of your portfolio if you have divided it up into a dozen particular investments.

Why No Cash?

The 60/40 allocation has no cash component. This is because it is assumed to be a long-term growth portfolio. Long-lived financial assets are priced in a fashion that they are expected to have a higher return than cash. For example, et would make little sense to own bonds, which can suffer losses of market value, if they were expected to have a lower return than cash.

Of course, these are just the returns that investors expect. In reality, stocks and bonds can lose money, and therefore underperform cash. But it seems unlikely that cash will provide higher returns over long horizons (for example, decades).

Cash weightings in portfolios should rise if your investment returns are shorter, or if you need it for liquidity purposes. (I have another article on the role of cash in portfolios.)

The 50/50 Alternative

Imagine that you were told that you had to choose between investing in two asset classes, but you were not told what those asset classes were. All the information that you are given is their names: asset class "A" and asset class "B".

Unless you feel like a gambling, your best option is split your portfolio 50/50 between the two asset classes. Any other choice means that you are overweighting an asset class, without having any information justifying that overweight.

This is how you should view the 50/50 portfolio weighting: you do not have information about which asset class will outperform.

60/40: A Measured Bet On Equity Outperformance

A 60/40 weighting implies that you expect equities to outperform. However, your confidence in equity outperformance is limited; you have not moved towards 100% equities.

At a 60/40 stance, you hold 1.5 times as much equities as you do bonds. This could be interpreted as you have 1.5 times as much confidence in equities as you do bonds.

But if you switched to a 80/20 weighting, you have moved to a 4:1 weighting ratio. You implicitly have 4 times as much confidence in equities as bonds.

Since it is difficult to have that much conviction on how well equities will do relative to bonds, it makes sense that recommended equity weightings are often around 60-70% for long-term portfolios.

For Shorter Horizons, Bonds Are More Important

If you have a shorter investment horizon, the logic is somewhat different. For example, you could be a retiree that needs investment income.

You are now are looking at the probability equities will outperform the yield to maturity of bonds. Since it is hard to guarantee such an event, recommended portfolio weightings start to switch towards bonds. This explains various rules-of-thumb which increase bond holdings as you age.

Uncertainty Versus Volatility

I think that looking at the portfolio weighting question in this way is more intuitive than a more common presentation in terms of the trade-off between expected returns and portfolio volatility. Technically, the two viewpoints could be seen as roughly equivalent. However, I would argue that it is hard to relate to the concept of volatility.

My concern with presenting the disadvantage of a high equity weighting as the portfolio becomes more volatile is that it is too easy to shrug off volatility. All you need to do is stop looking at your portfolio valuation, and it appears that it no longer matters that it is going up and down.

But if you express the desire to hold at least some bonds as a result of uncertainty. it becomes more clear why it may be dangerous to hold 100% of your portfolio in equities.

What Is Right For You?

I cannot give investment advice, so I cannot say what is the right asset allocation for you. Ideally, you could spend time studying how portfolios with different weightings behaved over time, and see whether the risk characteristics look appealing. A second best choice is discuss this with an advisor, and lean on that person's advice. If you are handling your investment decisions yourself, keep in mind this uncertainty concept, so as to avoid making too extreme investment decisions.

(c) Brian Romanchuk 2014

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