Posted December 29, 2023
By Zach Scheidt
The 60/40 Portfolio: Financial Advisor Caught Asleep at the Wheel
Three years ago, I had an argument with a friend.
Larry is a financial advisor and has built a large independent practice.
For the most part, I think Larry is a good person who wants to help people grow and protect their wealth.
But like many wealth managers, Larry is often much more focused on finding new clients than on helping his existing book of business manage their investments.
Larry prefers to put each investor into a “model portfolio,” or a cookie-cutter investment program, instead of actively choosing investments that will help optimize their money.
In 2020, wealth managers across the country still lauded the “60/40” portfolio as a safe and conservative way to invest (the 60/40 portfolio consists of 60% stocks and 40% bonds).
If you’ve followed me for some time, you know that I’m a proponent of balanced investment approaches.
And I strongly believe that diversification will go a long way in helping to preserve your wealth even in challenging environments.
But I won’t blindly follow some cookie-cutter model because it’s an “easy” way to invest.
We absolutely must think critically about how each area of our investment approach contributes to the overall picture.
“Larry, Treasury bonds are supposed to offer risk-less returns,” I told my friend.
“But with interest rates near zero, investors aren’t getting much return at all! Plus, they have a huge amount of risk if rates start to trade higher!”
Larry didn’t seem to care about the logic.
He just said, “Zach, people have been making that argument for years! And we’re still doing just fine. I’m keeping 40% of my clients’ capital in Treasury bonds and they’re going to be just fine.”
If only he knew…
The Punishing Crash of the 60/40 Portfolio
Not long after my 2020 conversation with Larry, inflation started picking up. The Fed called this inflation “transitory” at first and failed to act quickly.
But as the rate of inflation rose to 5%... 7%… and eventually over 9%, Fed Chair Jerome Powell finally stepped into action.
Since then, the Fed has engineered the most aggressive rate hike in our generation. During this time, investors experienced a devastating bear market in both Treasury bonds and stocks.
Investors across the country who followed the traditional 60/40 approach were absolutely crushed. And it will now take years for them to rebuild their wealth.
I never brought the subject up with Larry again. It’s not my style to say, “I told you so.”
But I’m troubled by the way that “Wall Street Wisdom” wound up leaving retirees in such a vulnerable place three years ago.
As is often the case, conventional wisdom can be a terrible influence when applied the wrong way.
To understand why the 60/40 portfolio was hurt so badly, it’s important to have a basic grasp of how bond prices work.
And the good news is that this knowledge will set you up for some extraordinary potential gains in 2024 as conventional wisdom is once again proved to be ill-timed at best.
How Bond Prices Respond to Interest Rates
You may have heard that bond prices move in the opposite direction from bond yields. But do you really understand how the relationship works?
Let’s look at a couple of examples to explain exactly why my friend Larry was putting his clients in a precarious position and why you have a tremendous opportunity in front of you right now.
Bonds are known as fixed-income investments because there’s a fixed amount you can expect to receive as an investor.
Basically, a company (or the U.S. government) owes bondholders a specific lump sum when the bond matures — and sometimes specific interest payments along the way.
Suppose you had a bond that paid you $1,000 at the end of one year. If the interest rate for this bond is 2%, you should be willing to pay just over $980 for that bond today.
Put differently, if you pay $980 and receive $1,000 in a year, your return will be 2%.
Now, suppose the interest rate for this bond changes to 5%. What would you be willing to pay for that bond today?
The answer is, roughly $950. Because if you invest $950 today and get $1,000 in a year, your rate of return will be roughly 5%.
So there is a mathematical relationship between current interest rates and what you should be willing to pay for a bond today.
Here’s the thing... The longer until a bond matures, the more interest rates will affect its price.
The table below shows how a 20-year Treasury zero coupon bond should be priced today based on a 2% interest rate or a 5% interest rate.
Start at the bottom of the table and notice how the bond matures at $1,000. So that’s what investors can count on receiving at the end of 20 years.
But depending on the interest rate, what you pay today for that bond can differ significantly. At a 2% interest rate, your 20-year bond will cost roughly $673.
But when rates are at 5%, that very same bond is only worth $377. That’s a huge difference for the same payout!
Now do you see why changing interest rates affect long-term bonds so much?
In part two of this series, which will hit your inbox tomorrow, I’ll explain what this means for you in the year ahead.
And it all ties back to one of my biggest predictions for 2024. Stay tuned for more!