For decades, many individual and institutional investors have used a 60/40 asset allocation as common strategy for investing in stocks and bonds. This rule of thumb came from the work of two Nobel Prize winning economists, Harry Markowitz (1952) and Bill Sharpe (1964), and their contributions to modern portfolio theory continue to drive today’s innovation in finance.
Since the dot.com bubble in the early 2000’s, and certainly since the Global Financial Crisis just over ten years ago, some have challenged the viability of the 60/40 approach and whether it properly manages investment risk. Some have also revisited whether or not the 60/40 philosophy can continue to deliver long-term investor returns which are necessary to meet future financial planning and retirement income objectives.
LIKELIHOOD OF SUCCESS AFTER 30 YEARS
Various initial withdrawal rates and asset allocations
Source: JP Morgan Asset Management; note that this chart is for illustrative purposes only and must not be used, or relied upon to make investment decisions. Portfolios are described using equity/bond denotation. Hypothetical portfolios are composed of All Country World Equity and U.S. Aggregate Bonds, with compound returns projected to be 6.0% and 4.0% respectively.
SHOULD OUR MARKET EXPECTATIONS CHANGE?
As investors balance risk in order to achieve necessary investment returns, it’s important to consider the impact sequence of returns risk can have on future income needs. However, as we’ve highlighted, the failure to achieve necessary investor returns can also have a dramatic effect on outcomes. For example, the above chart uses a 6% assumption for stock returns and a 4% return for fixed income returns over a period of time. Nobody knows for certain, but some may argue that a 4% return for fixed income is too high of an assumption given today’s interest rates. As a result of market structure (and normal stock market risk), this could change sustainable withdrawal rates as well as pose greater risk to investors.
In addition, as sources of guaranteed income disappear, retirees must rely on non-guaranteed income to fund their expenses. Under the old school of thought, investors saved during their working lives and cashed in those assets over their golden years, hoping they wouldn’t outlive their reserves. As investors balanced risk, they accumulated a portfolio combining “safe” assets, such as bonds, and “risky” assets, such as stocks. However, we also know investors benefited from:
A falling or stable interest rate environment, which supported a 30-year bond bull market
A steady and relatively low-volatility recovery in equities following the global financial crisis
It is possible that the structural forces helping past retirees are unlikely to persist. Interest rates are at or near historical lows and any increase can have a negative impact on the value of some bond allocations, which can also pressure all traditional asset classes. Of course, we know the future is hard to predict.
Unfortunately, as usual, there are many in the investment community who use this information for their own motives and its often not beneficial to consumers. Its during times like this of investor uncertainty and/or economic crisis that “guaranteed” products, exotic investments and high cost solutions with no merit or academic framework to back them up find their way into someone’s portfolio. While many of these are positioned as ways to better manage risk or achieve return, they often fail to deliver in more ways than one. As our clients know, one should use caution when confronted with many of these products.
At CAM, any and all reasoning takes an evidence-based approach. Diversification and proper asset allocation are some of the last free lunches available to investors and therefore we prefer an academic framework that utilizes research allowing us to think about the 60/40 problem differently. That research shows us that since 1964, the investable market has changed:
THE INVESTABLE MARKET HAS CHANGED SINCE 1964
Sources: Bloomberg; McKinsey; SIFMA; Morgan Stanley; BIS; Delotte; Stone Ridge; “Volatility” represents the global market for options; “Royalties” represents the global market for payments made to the owner of an asset for the use of that asset.
THE WORLD IS A BIG PLACE NOW
As you can see by the chart above, large public U.S stocks (i.e. S&P 500) no longer make up as much of the investable market as they once did. Not only have foreign stock markets, global real estate, and fixed income grown in size, so have other asset classes.
There are now additional investable options in today’s markets that didn’t exist before. Given changes in the market structure, this might suggest that additional diversification and wealth creation opportunities are available. However, it’s also important to remember that other key difference in today’s environment that will impact some investors’ ability to achieve investment goals, especially in retirement:
IS THE MARKET DIFFERENT NOW?
Source: Federal Reserve Bank of St. Louis, FRED Economic Data Period: January 1, 1964 to March 31, 2018; Source: Illuminating the Path Forward, Ross Stevens, Joshua Zwick, Randolph Cohen, February 2017, p 5.
Since 1964, interest rates, as measured by 10 Year Treasury Rates, have experienced significant fluctuations. Based on today’s rates, expected return in fixed income has declined much like our return on cash has. Many of us can still remember not too long ago when we could earn 6% or more on our cash and money markets. Unfortunately, this is not possible in today’s market. As a result, the investment return a 60/40 allocation achieved in the past may not be the same going forward. This could result in investors having to take on more risk, pursue other investment strategies, or save more for the future.
To add to the 60/40 debate, our research and academic findings suggest what some call “The Triple Threat”, deserves further attention:
Whether good or bad its no secret that our workforce is changing due to advancements in technology. For some, this creates the risk of reduced wealth creation during a period of time for restructuring while many workers need to be retrained and adapt to changing (dynamic) jobs. As the first tier in the triple threat is important, we recognize that the shifting of workforces will impact our investments.
FUTURE INVESTMENT RETURNS
A lower interest rate environment may not just impact lower returns in fixed income, but also other traditional asset classes. Many argue whether or not lower interest rates may result in less of a compounding effect or less overall wealth creation.
Also worthy to mention, it seems more and more evidence is suggesting that companies are staying private much longer given its often more attractive in the early years for small companies and shareholders. Many of these company leaders will tell you that they will only do an IPO when they have to, if ever. As a result, due to this delay in going public until a company is more stable and mature (i.e. a little less risky), the expected return (or equity risk premium) for these companies could be less. A few good names to consider are Microsoft and Amazon in terms of how small they were in market value when they went public ($778 million and $438 million respectively).Their incredible returns since their IPO has had a significant contribution to the equity risk premium. Now if we think about companies like Uber, Pelaton, and Lyft that are set to go public with market valuations between $4 billion and $100 billion+, one might ask if public market investors will benefit from as much upside or will the private equity/venture capital audience capture more of this. As we know from substantial research, only a small number of public companies drive most of the public market returns.
Until recently, the number one fear to the average person was speaking in front of a crowd. Times have changed. While many still fear public speaking, running out of money has become a leading cause of anxiety. Rapid improvement in health technology is driving some of this concern as cures are happening every day due to medical advancements. It is possible at this pace, we all live much longer than expected. How do we pay for this? In reality, few people exhaust all of their assets, but its true many are forced to cut their spending and/or seek help from friends and loved ones. For those who saved for a comfortable, independent, and dignified retirement, such outcomes are unacceptable.
The 60/40 investment debate is far from over. Even if future long-term equity returns equal those of the past, increased stock market volatility, advancements in technology, or greater longevity may undermine a retirees financial security. We know the future is impossible to predict. However, we’d rather use research, logic, and what we know today in order to best stack the odds in our clients’ favor. Hence, we think everyone should review their own situation and possibly revisit some assumptions for the future.
As always, we appreciate our relationship with you and we are here to help.