Why traditional balanced portfolio of 60% stocks, 40% bonds can still work for investors

Some financial advisers question the idea of having a bond-free portfolio

The traditional balanced portfolio of 60% stocks and 40% bonds has worked like that 40-year-old refrigerator in garage: It just keeps chugging along.

Some advisers are starting to worry that its core premise — that stocks and bonds move in opposite directions — might not be so reliable in the next bear market. But that might not be worth worrying about.

In hindsight, balanced portfolios have been one of the best investment strategies for the past 40 years. The top-performing balanced fund, Dodge & Cox Balanced (DODBX), has averaged a 10.95% annual return since 1976, versus 11.13% for the Standard and Poor’s 500 stock index with dividends reinvested. In other words, it’s 0.18 percentage points shy of an all-stock index with roughly 40% of its portfolio in bonds. You can’t beat that with a stick.

What’s more, the fund’s standard deviation the past 15 years has been 12.1 — high for a balanced fund, but well below the S&P 500’s 14.60 reading for the same period. (Standard deviation is a measure of volatility: The higher the standard deviation, the higher the investment’s volatility.) You’ve gotten nearly all the return as an all-stock portfolio, with less risk. It’s a wonderful thing.

If we were to just chalk up Dodge & Cox’s performance to sheer wizardry, which is possible, consider Vanguard Balanced Index (VBINX), whose record spans the past 20 years. You get roughly the same results. The Vanguard fund has gained an average 7.71% a year the past two decades, versus 8.21% for the S&P 500. And its standard deviation is just 8.93 the past 15 years.

Nevertheless, if you’ve rummaged through your closet recently, you know that what worked in 1986 probably won’t work that well today. And what raises worries in some advisers’ minds is that the current yield on the 10-year Treasury note stands at 1.69%, 9.08% at the start of 1986. versus 9.08% at the start of 1986.

It’s entirely possible that the stock market’s next big dive could be prompted by rising interest rates — after all, the market’s most recent tumbles this week were caused by fears that the Fed would raise short-term interest rates from 0.25% to 0.50%. In that case, both stocks and bonds could fall at the same time, prompting noises from your clients like a 40-year-old fridge that has just blown its fan.

Paul Singer, founder of the $27 billion Elliott Management, called bonds “the mother of all bubbles” on CNBC this week. He’s recommending gold. Kephos founder Mark Carhart suggested that investors ditch the bond portion of their portfolios and consider a trend-following strategy of futures and currencies, buying what is rising and selling what’s falling. And much of the increase in sales of strategic beta funds have played on the fear that the bond portion of a client’s portfolio won’t provide the protection it is used to.

But how likely is an interest rate spike? After all, it’s the bond market, not the Federal Reserve, which determines long-term interest rates. Bonds react, first and foremost, to the likelihood of inflation. While wages picked up last month, fears of fast-rising inflation appear to be overblown, writes John Lonski, team managing director of the Economics Group at Moody’s Analytics. “According to the CME FedWatch Tool, fed funds futures implicitly assign only a 15% likelihood to a September 21 rate hike and gives odds of merely 22% to a November 2 rate hike. The fact that the equity market has responded so negatively to talk of a tiny rate hike from 3/8% to 5/8% underscores the softness of business fundamentals,” Mr. Lonski said.

Steve Janechowski, a financial planner in Tiburon, Calif, said that anyone considering alternatives to a bond portion in clients’ portfolios should ask themselves exactly what they think will make a good replacement. A trend-following approach, such as Mr. Carhart suggested, would require full-time duty at a trading desk. “That one had me in stitches,” Mr. Janechowski said. Gold is certainly an uncorrelated asset relative to stocks, but it’s also highly volatile.

One alternative, suggested by Ted Johnson of Seeking Alpha, is a highly uncorrelated portfolio of high-yield bonds (corporate and municipal), real estate investment trusts, emerging markets bonds, senior loans and master limited partnerships. The hypothetical portfolio of ETFs has a current yield of 6% and a three-year standard deviation of 5.01. The portfolio’s correlation to the SPDR S&P 500 ETF is 0.62, which is relatively low.

Or you could look for investments with lower risk than stocks, but somewhat more risk than most bonds, suggested Barry Glassman, a McLean, Virginia-based financial planner. Those would include short-term high-yield bond funds, market neutral funds or even merger arbitrage funds. The latter, he noted, have been less rewarding as the risk of regulatory intervention in mergers have increased.
Of course, if rates were starting to rise, a simple alternative would be a Treasury or CD ladder — staggering maturities so that as each investment matured, you’d be locking in at progressively higher rates. For that matter, a money fund would provide a way to ride short-term rates upward.

And, while bonds look risky at these levels, the market has had several periods when both stocks and bonds sank at the same time — the most notorious being the runup to the 1987 stock market crash. Nevertheless, bond yields fell after the crash, and provided some relief — as did the market’s rebound in the wake of the crash.

“I question the wisdom that bonds are dead and you should get out of bonds,” Mr. Janechowski said.

Could you add a few non-correlated assets to hedge your clients’ bets. Sure. But a completely bond-free portfolio would probably be a mistake. Very few advisers thought Treasury yields would be this low. Even fewer German advisers thought their yields would be even lower.