Building an investment portfolio means determining the right mix of assets to help you reach your goals for the short and long term. One of the more conventional approaches financial advisors and experts suggest is the 60/40 portfolio. Going this route can make portfolio-building simple, but it’s not right for everyone.
What Is a 60/40 Portfolio?
“The 60/40 strategy involves constructing portfolios which are allocated 60% to equities and 40% to bonds,” said Tom Desmond, chief financial officer at Ally Invest. “The simplest implementation of the strategy would involve buying the S&P 500 and U.S. Treasurys.”
If you were to go that route, your portfolio would primarily contain U.S. investments. You could also build a globally diversified 60/40 portfolio by including international stocks and bonds as well.
In theory, a 60/40 mix allows you to maintain balance in your portfolio when the market is high and when it’s low. It’s designed to minimize risk while generating a consistent rate of return over time, even during periods of volatility.
“The main advantage of a 60/40 portfolio is that the bond allocation moderates the risk of the portfolio,” said Robert R. Johnson, a professor of finance at Heider College of Business at Creighton University. “That is, it allows investors to sleep at night.”How to Build a 60/40 Portfolio
How you go about adding investments to your portfolio with a 60/40 division depends on your investing style.
For example, DIY investors who are comfortable with a self-directed approach can construct a portfolio using low-cost exchange-traded funds (ETFs). ETFs are mutual funds that trade like stocks, so you get streamlined diversification while taking advantage of market movements. They’re also more tax-efficient than traditional mutual funds because the investments within the ETF don’t turn over as often.
There are other investment options to consider as well. “An investor with a current income need may benefit from dividend-paying stocks and real estate investment trusts for their equity allocation,” Desmond said. On the fixed-income side, he says investors may consider municipal bonds to benefit from tax-exempt interest. Another option is high-yield bonds, which can offer better yields but are riskier.
You could choose individual stocks. However, even historically well-performing stocks can have bad days. And if you put all your eggs in one stock basket, so to speak, you could rack up big losses if the stock drops.
“The returns on the market have been driven by a small percentage of big winners,” Johnson said. “Trying to pick winners, for most, is a loser’s game. The solution is to invest in diversified funds instead.”
If you’re investing in mutual funds or ETFs for the equity portion of your portfolio, pay close attention to the fees. Specifically, hone in on the expense ratio. This ratio tells you what percentage of a fund’s assets are used to cover its operating costs each year. The higher the fee, the more of your investment earnings you’ll hand over to own that fund.The Downsides of the 60/40 Portfolio
While a 60/40 strategy is an uncomplicated way to invest, there are some downsides to consider.
“The biggest disadvantage is that, over the long-term, a 60/40 portfolio will underperform an all-equity portfolio,” Johnson said. “And over very long time periods it will underperform by a significant amount because of the influence of compounding interest.”
In other words, you may be playing it safer with a 60/40 division of assets but you could be missing out on returns. Between 1926 and 2017, large-cap stocks such as the ones included in the S&P 500 returned 10.20% compounded annually, according to Morningstar. Over that same time frame, long-term corporate bonds returned 6.10% while long-term government bonds returned 5.50% annually.
An investor who sticks with a straight 60/40 mix could see returns on both sides. However, they could potentially shortchange their portfolio’s growth by not owning a higher percentage of stocks.Who Is a 60/40 Approach Right For?
The investor who stands to benefit most from a 60/40 portfolio may be the one whose risk tolerance doesn’t allow them to pursue a 100% equity allocation.
“A 35-year-old investing for retirement has the ability to bear risk because she has a longer time horizon but may not have the willingness to do so,” Johnson said. “That is, psychologically, she can’t bear the volatility in the equity market.”
The advantage of a 60/40 portfolio is that it is rules-based, Johnson said. “The allocations are fixed and one need not make allocation decisions during times of market instability.”
Desmond says this type of portfolio is likely better suited to someone who is towards the middle of their investing career. Someone in their 20s or 30s, for instance, who has several decades to go until they retire can take more risk and allocate more of their portfolio to stocks simply because they have longer to recover from any market declines. On the other hand, someone who’s closer to retirement would generally want to reduce exposure to stocks and increase bonds or fixed-income holdings, which produce more stable returns.
If you’re on the fence about whether it makes sense for you, Johnson says it helps to lay some ground rules for how you want to invest. Those rules should cover not only your time frame, goals and risk tolerance but also things like liquidity and tax efficiency.
From there, you can shape a target asset allocation that you want to maintain and a plan for rebalancing your portfolio as you near retirement. This does two things: It gives you a clear blueprint to follow and it can help you avoid making emotional decisions when the market zigs and zags.
The whole point of the plan is to guide you through volatile conditions, Johnson said. Your plan shouldn’t change because of fluctuations in the market.Alternatives to the 60/40 Portfolio
A 60/40 portfolio can offer a sense of stability where returns are concerned. On the other hand, it may not perform as well as other strategies. When you shape your asset allocation, it’s helpful to cast the net wider, then drill down to the approach that best fits your objectives.
For example, using your age to guide asset allocation is an alternative rule of thumb you might consider. You subtract your age from 110 to determine how much to allocate to equities and to bonds. So if you’re 40 years old, for example, you’d want to allocate 70% of your assets to stocks and the remaining 30% to bonds. If you’re comfortable with taking more risk, you could bump it up to 120 instead.
You also can use SmartAsset’s asset allocation calculator to determine the right asset allocation based on your risk tolerance. Talk to a professional if you need advice on your portfolio.The Bottom Line
In a 60/40 portfolio, you invest 60% of your assets in equities and the other 40% in bonds. The purpose of the 60/40 split is to minimize risk while producing returns, even during periods of market volatility. The potential downside is that it likely won’t produce as high of returns as an all-equity portfolio. But for investors who don’t have a high risk tolerance but still want growth potential, it’s a good option. Still, it’s important for each investor to examine their own situation and goals to determine their best asset allocation.Tips for Investing
Photo credit: iStock.com/alexsl, iStock.com/ridvan_celik, iStock.com/monkeybusinessimages
The post What Is the 60/40 Portfolio (And Should You Have One)? appeared first on SmartAsset Blog.
Information contained on this page is provided by an independent third-party content provider. Frankly and this Site make no warranties or representations in connection therewith. If you are affiliated with this page and would like it removed please contact email@example.com