Debunking the 60/40 Asset Allocation Approach

I remember an advertisement in the 1980's with GM trying to rekindle the Oldsmobile brand but proclaiming that "It's not your father's Oldsmobile." It obviously didn't work, and in 2004 the last Olds rolled off the assembly line. In a similar vein, the tried-and-true static asset allocation that has been preached for ages of having your investments allocated 60% to stocks (equities) and 40% to bonds (fixed income) has gone the way of Oldsmobile or for that matter, GM.

Well, I think 2008 debunked the belief that this static approach worked well, just like GM's marketing strategy failed to restore the tarnished luster of the Oldsmobile brand. Investors want a lot more out of their investment portfolio -- more downside protection, better upside capture, or at least more than a 60/40 portfolio can give them. Without discussing the merits of adding a tactical element to your investment process, strategically broaden your mix of asset classes and you'll get all the diversification, returns, and risk reduction you need.

Simply put, investors want the best of both worlds: the long-run performance of stocks with the downside protection of bonds. We all want high returns with low risk.

Cash and bonds, in general, produce lower average returns but also have dramatically lower risk - as measured by their worst 3 year loss, compared to stocks, real estate, and commodities.¹ The 39 year period from 1970 to 2008 is the basis for this analysis as well as 7 asset classes (cash, bonds, large US stocks, small US stocks, international stocks, real estate investment trusts, and commodities) . Over the 39 year period, the annualized return on cash was just over +6%. The worst 3 year cumulative percentage return for cash was about +4%. US bonds had a 39 year annualized return of over +8% and an even better worst-case 3 year cumulative return of +6.4%. Both bonds and cash present low risk investments as demonstrated by their worst 3 year return.

In looking at the remaining 5 asset classes, they had considerably higher returns but with dramatically larger worst-case 3 year losses. Large US stocks had a 39 year annualized return of about +9.5%, but also had a 3 year period in which it lost a cumulative total of over -37%. Higher returns are achieved, but at the price of significant short-run losses. The best performance individual asset was real estate. It had a 39 year return of +10.6%, but it also had a 3 year period in which it lost almost -32% of its value.

The Best of Both Worlds?

Is it possible to create a portfolio that achieves the returns of stock with the risk level of fixed income? Yes, but it requires broad diversification and strategic asset re-allocations that take into account the age and/or risk appetite of the investor.

The standard approach in attempting to reap the respective benefits of equities and fixed income is to create a "balanced" portfolio. The typical balanced fund has 60% stocks and 40% bonds. Generally, the stock portion is a fund that mimics the S&P 500 index (large US stocks). The bond exposure is generally an aggregate bond index or an intermediate bond index (both behave very similarly).

A balanced approach does in fact create a blended effect: performance that is comparable to individual stock assets (or close to it) with reduced downside risk. A 60/40 portfolio had stock-like return (+9.4% annualized return) with significantly lower risk. The worst 3 year loss for the 60/40 portfolio was about -14%. The classic 60/40 "balanced" portfolio moves us partially to the goal of equity-like returns with bond-like risk, but not close enough.

The risk/return characteristics of a balanced 60/40 approach are admirable, but better results are possible.

One obvious approach is to include all the other assets that a typical balanced approach chooses to ignore, namely small US stocks, international developed-country stocks, emerging market stocks, real estate, commodities, and cash. In essence, build a multi-asset portfolio. Second, strategically alter the asset allocation to increase the fixed income exposure and reduce the equity exposure as the investor ages. The risk/return characteristics of an age-sensitive multi-asset portfolio are truly amazing. 

Combining all seven assets (equally weighted and annually rebalanced) and applying an age-sensitive asset allocation model produces a 39 year average annualized return of +9.5% and a worst 3 year loss of +10%. Remarkably, the downside protection of the 7 asset portfolio was better than cash or bonds. Voila, stock returns with bond-like risk!

Assumptions Made

It was assumed that in 1970 (the starting year of this analysis) the investor was 25 years old. By 2008, the investor was 63 years old. The age-sensitive 7 asset portfolio utilized a dynamic mixture of the 7 asset portfolio and a separate fixed income portfolio (itself a mixture of bonds and cash) in which the annual allocation between the 2 takes into account the age of the investor. In this model there are no tactical decisions, the decisions are entirely strategic. That is, the asset allocation model is entirely known in advance and does not rely on market reactions or extraordinary insights to make the right allocation decision at the right time.

A Better Multi-Asset Approach

Building portfolios that have upside potential as well as downside protection requires 2 vital elements.

• First, the portfolio must have adequate asset diversification. 7 different equally weighted assets provide sufficient diversification.
• Secondly, the portfolio must have an age-appropriate asset allocation model. The age-sensitive 7 asset portfolio has both elements, and as such, it represents a blueprint for retirement plans at the individual or corporate level.

The economy and the financial markets are always most vulnerable to the shocks we can't predict. To be prepared for this, investors need to be well diversified. 2008 was an extraordinarily difficult year for everyone in the investment business. As the markets and the economy appear to be on the mend, the temptation is to relax and enjoy the ride. Before doing so, investors need to check that they are diversified enough to weather the storms that we know can come to bear.

¹ Thanks to Craig L. Israelsen, PhD, an associate professor at Brigham Young University, for his research. The information represents the 39-year period from 1970 to 2008. Indexes include: S&P 500 Stock Index; Russell 2000 Stock Index; Morgan Stanley Europe, Australasia, Far-East (EAFE) Developed International Stock Index;Barclays (Lehman Bros.) Intermediate Government Bond Index; 3-month Treasury bills; Dow Jones Wilshire Real Estate Investment Trust (REIT) Index; and Goldman Sachs Commodities Index.

Green Valley Wealth Advisors | Aug. 11, 2009

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