Too Little, Too Much, Too Many
“Balanced” portfolios seek to reduce volatility by including income-generating investments and accepting moderate growth of principal. In these uncertain times, what’s wrong with a portfolio that balances 60% stocks with 40% bonds? Before we answer, let’s set the stage with some historical data.
Based on data from Vanguard going back to 1926, the results look pretty good for a balanced portfolio, with an average annual return of 8.7% and losses in 21 years out of 91.
As one would expect, a 100% stocks portfolio during the same period had a higher average annual return (10.2%) and higher volatility (losses in 25 years out of 91).
On the other end of the spectrum, a 100% bonds portfolio had an average annual return of 5.4% and losses in only 14 years out of 91.
The fundamental problem with the 60%/40% portfolio allocation is that it’s a model designed to reduce volatility, which is not the same as risk, and which is not a rational objective for the multidecade investor. Effectively, it’s a palliative prescription and comes at the expense of forgoing significant lifetime returns.
To illustrate, investing $1 million in a balanced portfolio value compounding at 8.7% generates a value of $12.2 million after 30 years. By contrast, $1 million invested in a 100% stocks portfolio compounding at 10.2% over the same 30 years yields $18.4 million—50% more.
But notice that neither of these portfolios includes any allocation to short-term reserves (cash). With 10-year Treasurys currently yielding about 3%, a retiree with a $1 million portfolio and a 40% allocation to bonds would generate about $12,000 of annual interest income. The corresponding reliance on annual withdrawals from the equity portfolio to fund living expenses leaves this person dangerously exposed to the impact of a bear market, especially should one occur in the early years of retirement.
In the real world, the typical “balanced” portfolio owned by the average investor consists of too little cash, too much exposure to bonds, and too many types of equities.
Too Little Cash
Most investors simply have too little cash. Retirees should set aside an amount sufficient to cover two years’ worth of living expenses, so they can suspend their equity withdrawals if a long and/or steep bear market strikes relatively early in retirement. Those still accumulating funds for retirement should set aside one year’s worth of expenses as an emergency reserve.
Too Much Exposure to Bonds
To be sure, there is an important role for bonds in investors’ portfolios. Bonds are suitable for funding known future commitments that will become due and payable within five years. When purchasing bonds for this purpose, match the duration of the asset with the corresponding maturity of the liability. But buying bonds to diversify against the perceived risk of owning stocks—where volatility is falsely equated to risk—inevitably depresses portfolio growth in the long run. One of the iron rules of the capital markets is that anything that suppresses volatility commensurately suppresses return.
Too Many Types of Equities
The remainder of an investor’s portfolio should be invested in equities, preferably through a highly diversified, low-cost, tax-efficient vehicle such as an equity index fund. In fact, when it comes to building a fully diversified equity portfolio, an investor needs to own just two broad-based equity index funds.
As an illustration, consider the two Vanguard exchange-traded funds shown in the table below. Based on their combined holdings as of May 31, 2018, an investor in these funds would own shares in 9,956 of the leading companies in the world while benefiting from some of the lowest expense ratios in the industry—typically 90% less than comparable actively managed funds.
Unfortunately, the typical investor owns either too many common stocks (though still a tiny fraction of the number in the two-fund Vanguard portfolio) and/or too many actively managed mutual funds. The result is a leaky equity bucket, where a combination of management fees, transaction costs, capital gains taxes resulting from active trading, and underperformance siphon off returns that are otherwise available to the index investor who simply buys and holds.
The first step in designing a portfolio is to get the asset allocation mix right—which most individual investors fail to do. (For a quick tutorial, see our guide, Asset Allocation Made Easy.) Second, investors need to know what they own and why they own it. Why own a basket of common stocks or expensive actively managed mutual funds—with the unlikely goal of outperforming the market—when highly diversified, low-cost, tax-efficient equity index mutual fund alternatives are the superior and easier choice?
The key distinction is that your percentage allocations to cash, bonds and stocks will align with your individual circumstances based on a formula-driven methodology rather than being an arbitrary mix designed to reduce volatility or define a label such as “moderate” or “balanced.”
In psychology, heuristics are simple, efficient rules that people often use to make judgments and decisions. They are mental shortcuts that usually involve focusing on one aspect of a complex problem and ignoring others. The 60% stocks/40% bonds balanced portfolio concept is an example of a finance heuristic. It has intuitive appeal but is deeply flawed because it is too simplistic for the real-world needs of individual investors.