Is the 60/40 portfolio dead?

Hey, The Investor’s Podcast Network Community!

Welcome to The Investor’s Podcast’s new daily newsletter: We Study Markets.

We’re best known for our industry-leading podcasts, like We Study Billionaires, but we also wanted to bring you more frequent, written content too — alas, We Study Markets, the newsletter, was born!

In this new newsletter, we’ll deliver you useful insights each day, Monday through Friday, to better track and understand financial markets, and what it means for you, in just a few minutes.

Whether you’re a seasoned investor or just starting out, we’re here to help.

Now, enjoy the first-ever edition of We Study Markets!

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In The News

🔥 The Federal Reserve’s preferred inflation metric, which excludes energy and food prices, remains elevated in May (CNN)

Explained:

• Investors and consumers everywhere hope for a lasting reprieve from spiking prices. While the Fed hopes to achieve a ‘soft landing,’ where inflation can be cooled without causing a recession, this outcome remains uncertain.

What to do:

• Reports like these, though, show just how much of a challenge taming inflation will be, and as consumers and investors, adjustments are needed. See how inflation impacts your portfolio in our Deep Dive section below.

📉 Despite presenting itself as the digital asset alternative to mainstream banks, crypto lender Celsius was really just built on risk (WSJ)

Explained:

• Financial contagion has defined the digital asset space over the past few weeks with several high-profile failures from projects like Terra’s Luna and the hedge fund Three Arrows Capital. Many who have stored assets like Bitcoin with impacted digital asset lenders enjoyed high deposit rates yet now question whether they will ever see those funds returned as Celsius now appears to be insolvent.

What to do:

• While the crypto lending industry awaits regulation, it may be best just to stay on the sidelines. As they say, ‘not your keys, not your coins.’

💔 ‘Fragmentation’ in Europe? European Central Bank (ECB) seeks to resolve rising sovereign spreads on government debt amongst southern European members (Nasdaq)

Explained:

• As high inflation rates grip the U.S. and Europe, central banks have begun raising interest rates in response. Fragmentation refers to excessive differences in yields across bonds in the Eurozone for countries, Italy being of particular concern. The challenge will be combating inflation while minimizing financial shocks to more vulnerable economies.

What to do:

• If you hold any concentrated bets on Europe such as European equity ETFs, it’d be wise to ensure they’re currency hedged (the ETF’s prospectus will tell you this), as the Euro stands to continue weakening considerably relative to the dollar due to higher interest rates in the U.S. (this is because of what’s known as the ‘carry trade’, learn more here).

Deep Dive: The 60/40 Portfolio

As we’ve mentioned several times, surging inflation is a problem, and its effects permeate the economy and financial system.

Let’s consider this in respect to portfolios: for decades, the ’60/40′ split allocation between stocks and bonds has been investing dogma. Many of your friends, family, peers, and maybe even yourself subscribe to some variant of this strategy born from Modern Portfolio Theory.

In elegant simplicity, this basic structure has performed beautifully over time. Equities have appreciated due to earnings growth compounding year after year, and long-term interest rates have declined since the 1980s (falling rates mean increasing price returns for bonds).

The portfolio also benefits from historically favorable correlation and covariance relationships between stocks and bonds.

In other words, the portfolio stays steady as short-term price movements in stocks and bonds offset each other, with the covariance meaning that bonds also generally tend to fluctuate far less relative to stocks, making your portfolio more stable.

This strategy has worked well for investors because the U.S has mostly avoided prolonged periods of excess inflation, greater than the 2% targeted by the Federal Reserve in recent memory. The 2% target may seem somewhat arbitrary. However, this is the round number chosen, where academic studies have shown prices can gently rise without risking acceleration while also padding against deflation (the opposite of inflation).

In our economic system based on fractional reserve bank lending, the money supply should grow over time with the economy. The challenge is to consistently thread the needle between just enough growth in the money supply and prices without disrupting the status quo.

For more on inflation, deflation, and how the economic machine works, Ray Dalio has a wonderful short video explaining it all.

So what’s the issue?

With inflation measures like CPI running hot at over 8% on an annualized basis, the prospect of ‘stagflation’ looms.

This is a concerning scenario where not only does the economy fail to grow, which hurts stocks, but persistent high inflation forces central banks to raise interest rates and slam bond prices.

See our guide for understanding stagflation here.

This is exactly what we’ve seen so far this year, with the yield on the 10-year Treasury bond nearly doubling while the S&P 500 is down approximately 20%.

Understandably, many investors feel there’s nowhere safe to hide, and if stagflation becomes the new paradigm, the outlook for these asset classes is bleak.

The takeaway?

The 60/40 portfolio construct is under serious risk of obsolescence in light of our current inflationary circumstances.

It’s too early to declare the strategy dead. Still, investors would be wise to consider incorporating a blend of factors and alternative assets into their portfolios in addition to specific types of bonds. For example, increased allocations to:

• Value and momentum factors (learn about factor investing here).​​​​
  • Momentum strategies have proven to be less correlated with financial markets over time while yielding consistent returns.
  • Value stocks tend to fall less than other types of stocks during market downturns, though more cyclical or highly leveraged companies within this category may not hold up as well during a recession. Buyer beware.
• Short duration investment grade bonds…”When the curve is as flat as it is, shorter bonds offer all the yield of the long end with less rate sensitivity” (FT)
  • Yes, you’re still losing to inflation based on its current levels, but inflation is unlikely to stay this elevated indefinitely. These yields are far more attractive than normal savings accounts while carrying a nice spread over government bonds with little default risk.
• Treasury inflation-protected securities (TIPS).
  • “The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.” (learn more about these special government bonds here).
• Real estate, particularly real estate investment trusts.
  • These income-producing assets, that yield meaningful cash flows because they are required to pay 90% of net earnings as dividends, tend to be less sensitive to inflation than traditional stocks, because these cash flows can be continuously reinvested.
  • Another great strategy here is relying on experts who help you invest in real estate directly. We love to do this with a little help from our friends at passiveinvesting.com.
• Commodities, such as oil, silver, and copper
  • These tend to hold their value on an inflation-adjusted basis due to their fundamental role in global economic activity.

Our friend David Stein, host of the podcast Money For the Rest of Us, has an excellent guide to understanding and protecting against inflation.

Quote of the Day

“You get a lot of A’s and B’s in school. In the stock market, you get a lot of F’s. And if you’re right six or seven times out of ten, you’re very good.”

— William Green in Richer, Wiser, Happier

Meaning

Investing is no pursuit for perfectionists, as even the very best investors tend to miss on half or more of their bets. In reality, investing is a blend of both art and science, and exact precision has proven unattainable.

In last Sunday’s We Study Billionaire’s episode 460, Lauren Templeton emphasizes exactly this when reflecting on her great uncle, Sir John Templeton’s career as one of the best stock pickers in the world, saying that he was right just 60% of the time.

For us mere mortals, the thought that we can at best only be right a fraction of the time is alarming, but the trick that great investors like Templeton use is to make concentrated bets with asymmetric returns.

This means that they find strong companies that are deeply undervalued, and if their thesis fails to unfold, they don’t stand to lose much, whereas if they are right, the returns can be huge over time.

To hear more about how legendary investors think, listen to the full interview here.

ABCs of Investing: Always Be Compounding

Investing for the long-term is no easy thing, especially during such tumultuous times. Sometimes, we overlook small tweaks that could make huge differences in building wealth over time.

For example, one study found that 17% of Americans with eligible 401(k) plans do not participate in these tax-advantaged retirement savings. Of those participating, 12% don’t contribute enough to capture their full employer match. Since the average employer match is around $1,780 (per Fidelity), millions of Americans are not only neglecting advantaged investment accounts, but they’re missing out on thousands of dollars that are available to them.

Investing is hard enough, so whether it’s in avoiding high-fee mutual funds, participating in tax-advantaged accounts like 401(k)s, IRAs, HSAs, and 529 plans, capturing your full employer match, or just rebalancing consistently, check out our ultimate guide to investing – we help you find the best ways to keep compounding.

See You Next Time!

That’s it for the first edition of The Investor’s Podcast new daily newsletter, We Study Markets!

If you enjoyed the newsletter, keep an eye on your inbox for them on weekdays around 12pm EST, and if you have any feedback or topics you’d like us to discuss, simply respond to this email.

Have a great weekend and Fourth of July!