Thursday, October 10, 2019

60% stocks and 40% bonds... not so fast

Investing can be intimidating. So for most folks, it’s easiest to follow the basic principles and pray you don’t screw up.

Perhaps the most basic portfolio management principle that’s taught to novices is that stocks can generate higher returns than bonds. But also, stocks are riskier than bonds. Therefore, it is recommended that investors diversify their investments — it’s why diversification is referred to as the only “free lunch” in the investment world — putting some in stocks and some in bonds.

And thus was born the 60/40 portfolio: 60% in stocks and 40% in bonds.

“The relationship between bond and equity returns is one of the fundamental building blocks of modern financial portfolios,” Bank of America Merrill Lynch’s Jared Woodard wrote in a note to clients on Tuesday. “It drives conventional ideas about benchmarks such as a 60% allocation to equities and 40% allocation to fixed income.”

But now, this might not be enough to generate the returns that investors have come to expect from the traditional 60/40 mix, which has returned about 6% a year since 1970.

As Woodard observes, bonds haven’t been behaving the way they’ve been expected to behave, especially relative to stocks. Specifically, they’ve been spending more time moving hand in hand with stocks, and generally speaking bond prices have become more volatile. And at least some of that volatility may be explained by the fact that the bond trade is incredibly crowded.

This is captured neatly by the fact that both stock prices and bond prices are near record highs (bond prices rise when yields fall).

“Today, that relationship is changing, raising the question: is 60/40 dead?”

This could have some serious consequences for investors who invest this way. Specifically, when things get ugly in the financial markets, bonds may not offer stability. Rather, they may actually make things worse.

For Woodard, the likely scenarios for the next couple years don’t look favorable for folks who set their 60/40 portfolio and forgot about it.

“60/40 may have thrived in the 2000s and 2010s but will not survive the 2020s,” he said.

“Either global growth & inflation will accelerate, handing huge losses to bondholders, or monetary policy will prove increasingly impotent to confront global secular stagnation, resulting in more frequent recessions and bear markets.”

Investing is hard. Even the easy parts.

By Sam Ro, managing editor. Follow him at @SamRo

What to watch today

Earnings

Pre-market

• Delta Air Lines (DAL) is expected to report adjusted earnings of $2.26 per share on revenue of $12.61 billion