Is the 60/40 Stock Bond Portfolio DEAD?

Troy Sharpe: For decades in this country, the conventional wisdom when you enter retirement is to invest your money in a 60% stock 40% bond portfolio. There are probably hundreds of billions of dollars invested in this model right now. In this video, we’re going to dissect if that portfolio was dead or if it’s still a viable retirement investment strategy.

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Hi, I’m Troy Sharpe, CEO of Oak Harvest Financial Group, certified tax specialist, CERTIFIED FINANCIAL PLANNER™ Professional (CFP®), and host of The Retirement Income Show. In order to help you understand whether the 60/40 portfolio was right for your retirement, we first have to provide some historical context, and then relate that to today in the environment that we’re currently living in. At the end of this video, I’m going to share a few things that you need to be aware of or at least understand the concept because these are various choices that are out there, and you need to understand how they can help or hurt your portfolio.

Providing some context here. When we talk about bonds, because this is what I’m going to focus on in this video. We’re big believers in the stock market long time. We believe that corporations are going to continue to make profits, revenues should grow, profits should grow, and margins should expand. This means the stock market should do well over the next 20 to 30 years. Now, in the interim, of course, there will be volatility, and investing involves risk, including the possible loss of principal, but the stock part we believe long term 20-30 years from now, the stock market will be worth a lot more in the future than it is today. I’m not going to spend a lot of time with stocks. I’m going to focus on bonds.

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Bonds are confusing for a lot of people, but here’s something that most people don’t know. The bond market is far more– I don’t want to use the word prescient, but a lot of times it’s more accurate, at least in terms of predicting prices, future movements. It’s mostly large institutions with sophisticated computers and a lot of education and experience trading in the bond market.

First, I want to talk about some very basics when it comes to bonds because I’m going to use these terms and it’s important that you understand what they are. First and foremost, we have yield versus price. When you own a bond or a mutual fund of bonds, it pays off an interest rate, that interest rate is the yield. The price is the actual fluctuation in price of that bond or that mutual fund. Yield is the interest rate. Price is the actual price of the underlying security that you own. It can go up and down.

Length of maturity and sensitivity. The longer the maturity of your bonds, the more sensitive they are to interest rate increases. If we have a 10-year bond or a 20-year or 30-year, that’s a longer maturity, they’re more sensitive to changes in interest rates. This means if interest rates go up, your longer maturity bonds will typically go down in value much more severely, so understanding this relationship.

I’m not going to get into this too much, but we’re going to focus on the 10-year Treasury today. The 10-year Treasury is a government bond. There are also corporate bonds that you can invest in. It’s very basic sense. A bond is something representative of a loan. You loan your money to the government or to a corporation and in turn, they give you an interest payment in return annually and promise to give you your money back at the end of that term, whether it’s 10 years or 20 years or 30 years. It’s a very basic understanding of bonds, but that’s how they initially work.

Government bonds are considered to be the safest asset in the world because the United States government can essentially print as much money as it wants and it promises the full payment of all of their obligations. Corporate bonds definitely more risky than government bonds. They’re broken down into investment-grade and junk bonds. Investment grades are anything rated BBB and above. Anything below that is considered a junk bond. We’re not going to focus on these today.

Now, for some historical context. Most of you are aware that interest rates have come down over the past 30 or 40 years. I’m going to actually show you that. Here we are, 1978. Interest rates are rising, so this is the average yield on the 10-year government treasury. If you loan your money to the government for 10 years, this is the interest payment that you would receive in return annually on average for those 10 years.

We see interest rates rising until we get to about 1981, 1982, and then, we start to see from 1982 up to 1989, interest rates dropping. As we get into the ’90s, we see interest rates for the most part decreasing. Then, we get into the 2000s, we see interest rates decreasing further. This is where we are today. Over the past 40 years, we’ve seen interest rates for the most part go down.

Now, when we contrast that with the actual price of the 10-year Treasury, remember the very beginning, the yield versus price, we just went through the average yield over the past 40 years. This chart here shows you the price of the treasury over the past 40 years. Goes back here to 1982 actually, 1982, 1983, 1984, we see the price, generally speaking, increasing.

It has some ups and downs like anything, but that’s good to point out that even when we own bonds, they’re not a 100% safe as far as market value fluctuations. Bonds do and can go down in value. They can also increase in value, but they’re not neutral. We see here, over the past 40 years, bonds have went up. What does this tell us? This very clearly shows that as interest rates have come down, the value of bonds has gone up. Now, we’re going to segment this out over a decade to give you a more clear view and tied into is that 60/40 portfolio debt.

1980, 1990, 2000, 2010, and today, this is the average 10-year yield. Now, I’m recording this video mid November 2021. The 10-year Treasury is actually a little bit higher right now. This is the average rate as of the last publishing for 2021. Once again, we see very clearly that interest rates have come down, and again, prices over that same time period have gone up.

This is a very important concept, when we’re talking about is the 60/40 portfolio dead? It is the concept of the nominal rate of return versus the real rate of return. These are the nominal yields for the 10-year Treasury in these specific timeframes. That just means it’s the interest rate you were earning before inflation. To calculate, the real return, which is what the interest rate is minus inflation leaves you with the real return.

This is the formula. It’s 1 + the nominal rate or 1 + whatever interest rate you’re looking at for corporate bonds, for government bonds, et cetera. We’re looking at government treasuries here, 10-year treasuries. 1 + the nominal rate divided by 1 + the CPI. This could be a different number. It’s whatever interest rate you’re trying to compare and contrast. – 1 = the real rate of return.

Now, we want to look at what is the real rate of return for owning bonds, specifically the 10-year Treasury, inside your portfolio today taking into account inflation. Here we have, from the Minneapolis Fed, the consumer price index in 1980, 1990, 2000, 2010, and then today. This is again the 10-year average treasury yield for those same corresponding years, and I gave you the formula.

I’ve done the math for us here, but in 1980, the real return for owning a 10-year Treasury, even though the nominal interest rate was 11.43%, inflation was higher than that. Your real return, when you run it through that formula, was -1.82%, so you were losing almost 2% per year by having your money inside a government bond. As you see, as the time goes on, these are the real returns after inflation of owning a 10-year Treasury.

Today, we’re at -4.5% about. When taking into account inflation, you’re losing about 4.5% right now for owning government bonds inside your portfolio. The real question then becomes, we already know we’re losing 4.5%, how long will investors continue to hold government treasuries at a -4.5% clip? Probably not too long. This is where the discussion around whether inflation is transitory. Will it be here for three months, six months? Will it be here for one, two years, four, five years?

This is why it’s so important, because at some point, investors, especially institutions, now most consumers aren’t even aware of this concept, so they’re going to take the advice of the broker or the banker or whoever they’re with. They’re probably going to say, “Yes, I want to stay in bonds because I don’t want to go into stocks because those big brokerage firms are very limited in the choices that they cannot offer. Typically it’s only those two primary asset classes.

Are institutional investors going to continue to hold government treasuries when the real return on those assets is negative four and a half percent a year? Probably not. What happens is, when they start to sell, because they don’t want to own that asset, they’re losing four and a half percent per year, it drives prices down. When prices go down, of course you’re losing money. This is how we can see big dips in bond prices. Now, again, my goal here is to convey the risks of inflation and owning bonds in a retirement portfolio, especially to the degree of 40% of your assets.

A couple of takeaways. What does this mean for you? Well, one, if you own 10-year treasuries, your real returns are about negative four and a half percent, but that’s just looking at the interest rate. If institutional investors decide they’re no longer going to hold those and they sell them, now, the price can also go down. This creates almost a double whammy. Not only are you not earning enough interest to keep up with your standard of living, but now you’re worried about market fluctuations, market risk, because if people start selling and the prices go down, now you can have tremendous losses inside that portfolio.

Keep in mind, the reason the 60/40 portfolio was pushed for so long is because when we look back at the chart interest rates in 1990, 1998 were very high. You could put your money into a government bond, earn eight and a half percent and as interest rates were forecasted to come down over the next 30 years, the capital appreciation of that bond, you’re expected to go up. You’re expected to increase in value.

The environment. The main takeaway here is that today the environment is completely different than the 1980s, 1990s, even 2000s. Not only were you earning higher interest, but when interest rates came down, you were having capital gains in your bond portfolio. Today, it’s the exact opposite, we’re earning low interest, and when rates go up, bonds go down.

Second takeaway here is that inflation is horrible for bonds. If inflation is here to stay, and I mean for the next one, two, three, four years, I would expect massive losses inside bond portfolios. As inflation, as I’ve shown you, gets higher, the real return of that bond goes down. Institutional investors are not going to sit in an asset class that is losing 4 or 5% a year. That’s going to create possibly a sell off, which would then drive the price of your bonds down.

There’s a lot of risk here with inflation, specifically as it pertains to your bond portfolio. Again, there are hundreds of billions of dollars. I’m sure you watching this video right now, probably have a significant portion of your money in bonds. Maybe some of you don’t, but whatever portion you do, it’s important to understand these relationships and the historical context that helps to tie it all together.

In summary, is the 60/40 portfolio dead? Well, I guess it depends on what your goals are, just like anything else in retirement. I did a quick weighted average calculation, and I’m being nice here to bonds, honestly. Looking at a 60/40 stock bond portfolio, assuming the stocks, which is the 60% earn 9% a year– again, this is average rate of return. I hate average rate of return in retirement because the most important thing is the sequence of returns. I have lots of videos out there on the sequence of returns and why it’s so critical in retirement.

If you’re in the accumulation phase, average rate of return is far more important, but the goal with this exercise is just to simply show you to put into context, the possible rate of returns for a portfolio that’s 60/40 moving forward into the future. I’m not quite sure how accurate this is simply because we could see negative returns absolutely on a real basis– This is all nominal, moving forward into the future.

If interest rates start to rise, bonds could lose money for several years in a row, especially on an inflation adjusted basis if inflation is here to stay. I’m being generous and saying, if stocks average 9%, bonds average 2%, it’s called a weighted average calculation, the total portfolio, very simple terms, would average about 6.2% nominally. That means prior to inflation. You would then do that calculation earlier based on the formula that I showed you earlier, based on what the CPI is to get your real rate of return for this portfolio.

If stocks average 7%, bond still at 2%, now we’re looking at a 5% nominal rate of return. I believe forecasting over the next 10, 20 years with different asset classes will, or how they will perform is a fool’s errand, because there are so many things that could happen that we have no idea about. First and foremost, many people don’t think the stock market will average 7 or 9%. Well, the truth is, valuations can be considered pretty high right now, but there is still opportunity out there.

Additionally, 10 years ago, no one would have said the stocks– they weren’t. No one was, as a matter of fact, saying the stocks were going to average 14% or 15% a year over the next decade. Now, most of that has been induced by the Federal Reserve nonstop printing money to support the financial markets. They’ve made it very clear, they are willing to step in at the first sign of any catastrophe, any significant recession, any significant decline in the stock market. I don’t know what stocks are going to return. If we go from 2000 to 2009, what’s known as the lost decade, stocks actually lost money over that 10 year period. I don’t know. It’s a fool’s errand.

Bonds, I think, are more likely to lose money over the next 10 years than stocks. I just want to, again, convey some simple math to help most people understand what some potential scenarios are. You see the calculation, you can do this yourself. If you think stocks are going to return five and bonds negative one, do the calculation. This is for you to learn and for you to apply to your own situation. Is the 60/40 portfolio dead? Well, again, it depends on your goals, your specific circumstances. If you’re happy with just 3% or 4%, I think a 60/40 portfolio can probably get it done for you. If you need 7% or 8%, no, probably not. A 60/40 portfolio probably will not get that done in my opinion.

Now, beyond what your goals are, you have to be able to analyze other tools in the marketplace that can be alternatives to bonds that can give you higher potential returns for less risk. There are tools out there in the marketplace. Heading into 2022, we’re going to begin an entire series to help educate you about what some of your alternatives are to bonds. As far as the 60/40 portfolio is concerned, there is no general right answer to this, like many things in finance, in retirement planning, or at least financial planning and in retirement focused financial planning.

It depends on your needs, it depends on your situation, of course, it depends on the actual returns of the various asset classes. That’s just an average. What happens if bonds lose 15%, and stocks lose 15% over the next year, and then the following year, they lose 10% and 10%? I don’t care what the averages are over many, many years, that’s going to put you into a pretty tight spot. Again, just average rate of return calculations, but the sequence of returns matters far more in retirement than the average.

I promised you some things that you need to understand or you need to be aware of. This is very important, because again, bonds can go down for a couple of reasons. One, there’s a massive sell off in the bond market, because of the real returns, is a great example of why, there could be others. If there’s a massive sell off, we could see prices go down. Another one is that if interest rates gradually start to rise.

Typically, a 1% increase in the interest rate environment, it’s a general rule of thumb, there’s some variables here. Generally speaking, you could expect to lose on your 10-year bonds around about 8% to 10% of its value in the short-term. It could go down if interest rates in the general environment go up about 1%. That’s on a 10-year bond. If you own a 30-year bond, and interest rates go up 1%, you could lose a lot more, substantially more, possibly 15% to 30% just from a 1% rise in interest rates.

If you think about it this way, if I own a bond paying 4%, and now interest rates out in the marketplace are offering 5%, why would anyone buy my bond at 4% if I wanted to sell it? They wouldn’t, because they could just go to the bond store and buy a bond paying 5%. In order to entice someone to buy my lower interest paying bond, I would have to drop the price. That’s why when interest rates are higher in the market, bonds go down in value. Because they’re not as attractive of an investment as something paying a higher interest rate, so the price must be discounted to make it more equivalent.

CEF. We see these a lot inside people’s portfolios. I guess I shouldn’t say a ton, but we definitely see them a lot. I hear a lot of people making comments on the YouTube channel here about these investments. This is called a closed-end fund. There are closed-end funds out there where you can make 7%, 8% interest. It’s not guaranteed, of course, but it’s a high risk type endeavor. The reason why these funds can pay 7% or 8% interest is because about 70% of the closed-end funds out there and those are the ones that pay the higher interest rate, they’re essentially buying on margin inside the fund.

Let’s say they pooled $100 million to create a fund. They’ll use that $100 million as collateral to go out and borrow maybe another $30 million. Then they’ll take that $30 million and buy more bonds to create more interest in the fund. What happens when the bond market sells off? You think bonds can go down in value. A normal bond could be possibly scary based on what I said before. If you have leverage inside your bond funds, it can be magnified, the potential for loss.

These closed-end funds, many people don’t understand that, yes, you can make a 7% interest rate, but you’re going to see, most likely, tremendous volatility inside that fund and possibly be stuck with massive losses. It is a high risk endeavor. There’s nothing out there that’s going to pay you 7% or 8% and it’s going to be secure. We’re just in a very low interest rate environment.

Thank you for watching this video. Again, subscribe to the channel, comment down below, share this video with a friend or family member, so we can help more people stay more connected to their money.

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