Part one of this two-part series explored why the future expected returns of the 60/40 portfolio are unlikely to match the last ten years.

In a nutshell, negative real bond yields plus richly valued US equity markets imply weak capital growth ahead.

Past experience shows expected returns predictions are more reliable than some chancer with crystal balls telling you that a dark, handsome stranger lies in your future. But not by as much as you’d think.

Still, a deluge of fiscal stimulus and near-zero interest rates has created a sticky financial quagmire. As a result, returns could be muted for a while.

In the face of all this, you can better position your 60/40 portfolio. But there are no magic bullets.

The alternatives come with consequences.

I’ll take you through the non-magic bullets you can fire in a moment.

First though, let’s talk about what not to do.

Don’t buy it

Improving expected returns typically means taking more risk. That’s the trade-off ignored by most of the 60/40 portfolio articles dominating Google.

Here’s a selection of their suggestions for your portfolio:

• Uranium
• Big tobacco
• Russian equities
• Private equity
• Hedge funds
• Timber
• Collectibles
• Music royalties
• Currency trading
• Junk bonds
• Chinese government bonds
• Infrastructure

The correlation between these ideas? They offer hope and are difficult to falsify. So let’s be clear. This is rampantly speculative stuff from the Donald Trump School of Medicine.

These articles are mostly generated by active managers and / or journalists. Their stock in trade is the turnover of ideas, not their quality.

60/40 portfolio: guiding principles

Recall that the 60/40 portfolio’s asset allocation aims to:

• Control risk and cost.
• Be simple to understand and operate.
• Work for investors with little interest in the market’s machinations.

None of those principles apply to the schemes I listed above. Mostly they’re complexity masquerading as strategy:

• Each ‘idea’ increases your exposure to risk and cost.
• They typically involve chancing your arm in opaque markets, which shortens your odds of being the sucker at the table.
• Little to no evidence is given to explain why these options are a good choice.

Sure, a couple of those suggestions may outperform a 60/40 portfolio in the next ten years.

But which ones?

In contrast, the following articles deploy evidence and data to expose how directionless some of those ideas are:

• The track record of hedge funds.
• Same again for private equity.
• Why narrow investment bets are a crapshoot.
• How recurring ideas like infrastructure, timber, and clean energy under-performed the broader market in the past decade.

As for Russian equities – they have been abysmal since at least 2007.

Moreover, autocratic leaders like Vlad Putin and Xi Jinping derive credibility from painting the West as an adversary.

Good luck landing outsized future cashflows as a foreign owner of Russian or Chinese securities.

Ditch bonds

The other ‘big idea’ you hear a lot these days is to drop bonds.

That’s because owning a large holding of government bonds right now is like riding a bicycle with a slow puncture.

But getting rid of them – or even switching up to a 80/20 portfolio? That ignores why government bonds are a mainstay of the 60/40 portfolio.

Holding bonds was never about earning big returns. The point of bonds is to lower the risk of you selling out when stocks crash.

Bailing can permanently damage your returns.

Yet this danger of cracking under pressure is not well understood, especially given how a bull market buries memories.

Panic is an insidious threat because we underestimate it.

Markets can be more brutal than most of us have experienced.

That’s why bonds are still a good investment, even today.

Some commentators state bonds can no longer protect your portfolio, but that’s not true.

These pieces show you why bonds retain some protective power, even at negative rates:

• How bond prices work.
• What bond convexity is and why it matters.

Alright, that’s enough about what not to do. Now for some practical suggestions for 60/40 portfolio investors.

Can you take more risk in your 60/40 portfolio?

The risk of investing in volatile asset classes means the answer to our malaise isn’t: “throw your bonds overboard.”

However, can you live with fewer bonds and more equities?

Can you handle a 70/30 portfolio, for example?

The answer will be very personal.

I’ve previously compiled the best advice I’ve found on risk tolerance to help you explore this issue.

One option is to try an industry-standard, online risk tolerance questionnaire. The idea is to discover the riskiest allocation you can comfortably deal with.

The big debate is whether such questionnaires work. The finance industry has used them for ages. But clearly they’re an imperfect measure.

So only increase your equity allocation cautiously and thoughtfully.

More risk, more reward?

Beyond incrementally revisiting your asset allocation, I wouldn’t recommend making changes on the risky, growth side of your portfolio.

That’s because the other options increase your exposure to investment risk and/or the risk of being ripped off.

For instance, long ago I invested in risk factors. The promise was outperformance in exchange for more risk.

Of course, I knew there was a chance my factor bets would disappoint.

Guess what?

I got the risk but not the reward.

Oh, and let’s shoot another white elephant in the room while we’re here.

The SPIVA study shows that active management is no solution either.

Remember, all the active money in the market – added together with all the passive index funds – is what makes up the market.

That means active management is a zero sum game because when one active fund wins another loses. Or more accurately: when one actively invested dollar or pound beats the market, another must do worse.

Active funds in aggregate can only deliver the market return – minus their higher fees.

The bond trade-off

Is there more you can do with your defensive asset allocation?

Perhaps.

Today’s government bond environment feels like a Tarantino-style Mexican standoff:

• Long bonds are your most potent protector against a deflationary recession.
• But they could inflict equity-scale losses if inflation runs wild.

• Index-linked bonds are your best defence against galloping inflation.
• However they won’t do much in a recession. And their yields are more negative than conventional bonds.

• Short bonds are as much use as a concrete zeppelin in a recession.
• But they’ll do okay-ish if the issue is inflation.

• Cash should be part of your mix, but it isn’t a panacea.

Which way do you turn?

Many fear the return of 1970’s stagflation will financially embarrass us like a kipper tie of woe. Meanwhile, the next recession is a ‘when’ not an ‘if’.

We need a portfolio for all weathers.

An intermediate gilt ETF holds short and long UK government bonds. It’s a muddy compromise that offers decent downside protection in a recession.

And owning some inflation-resistant, index-linked government bonds is de rigueur – even though they are expensive.

I discussed some linker options in this post. (Another global index-linked bond ETF (hedged to GBP) has come onto the market since.)

Fiddling around the edges

Higher-yielding bonds like corporate bonds and emerging bonds are not an alternative to high-quality government bonds in a 60/40 portfolio.

Emerging market bonds behave more like equity. You don’t need them. 

Investment-grade corporate bonds offer a little more yield in exchange for less protection than high-quality government bonds.

You’ll probably see owning US Treasury bonds mentioned, too. It’s a decent idea that could offer a smidge of extra return. But it only works under specific conditions. And the risks need to be understood.

You’ll have noticed by now that every ‘if’ comes with a ‘but’.

I prefer to keep things simple:

• Equities for growth.
• Index-linked bonds for inflation protection.
• Cash for short-term needs.
• An intermediate bond fund to cushion stock market falls.

However, I’ve been tipped off about a bond allocation that might work more effectively in the current conditions.

It’s an advanced strategy that requires a good understanding of bonds.

Long bond duration risk management

One logical response to a low yield world is to make like American politics and move to the extremes.

That means replacing intermediate and short bonds with long bonds plus cash.

This barbell approach hopes to capitalise on:

• The slightly higher yields of long bonds.
• Their better track record in recessions, relative to other bonds.
• The low duration risk of cash. This offsets the vulnerability of long bonds to rising market interest rates.

Here’s an example:

Desperate Daniella holds 100% of her bond allocation in an intermediate gilts fund with a duration1 of 10.

She replaces that fund with:

• 50% Cash (duration 0)
• 50% Long gilt fund (duration 20)

Daniella’s reallocation still leaves her with a weighted duration risk of 10:

• Duration 0 x 50% = 0
• Duration 20 x 50% = 10

The long bond duration risk is dampened by the cash.

This is not a free lunch. It gives you greater exposure to the longer end of the yield curve. That could be hard to live with should that part of the curve steepen in response to, say, spiraling inflation.

The idea comes from Monevator reader and hedge fund quant, ZXSpectrum48k. I’ll refer you to some of his comments on the topic:

• First comment
• Second comment
• Third comment
• Fourth comment

What about gold in the 60/40 portfolio?

From a strategic perspective, the best thing going for gold is its zero correlation with equity and bonds.

Gold randomly does its thing like Michael Gove in a nightclub – spasming erratically regardless of the drumbeat moving other assets.

Gold did amazingly well in the stagflationary 1970s. Back then equities and bonds got hammered. However, one-off historical factors were in play. The US Government had stopped fixing the gold price and legalised private ownership.

The yellow stuff smashed it during the Global Financial Crisis, too. But gold cushioned portfolios less successfully than gilts in the coronavirus crash.

And gold lost 80% between 1980 and 2000.

So no, gold isn’t a no-brainer. You still have to use your nugget. (Alright, that was just gratuitous – Ed).

Some model portfolio allocations like the Permanent Portfolio and the Golden Butterfly include a generous dollop of gold. How clever that looks depends mightily on the timeframe you pick.

Meanwhile, gold’s long-term return hovers right around zero. It’s crock-luck as to whether gold will work for you. The hope is it comes good when everything else fails.

For me, this boils down to a 5-10% allocation in a multi-layered defence.

Where does that leave the 60/40 portfolio?

We live in interesting times. Diversification remains the right approach.

The all-weather portfolio below is positioned for uncertainty, without sacrificing the principles that first made the 60/40 such a godsend.

• 60% Global equities (growth)
• 10% High-quality intermediate government bonds (recession resistant)
• 10% High-quality index-linked short government bonds (inflation hedge)
• 10% Cash (liquidity and optionality)
• 10% Gold (extra diversification)

This asset allocation maintains the 60/40 portfolio’s balance of growth and risk. Granted, it adds complication. But every asset has a clear strategic role.

That makes more sense than knee-jerking into private equity and uranium.

Remember the 60/40 portfolio was never a get-rich-quick scheme. It gained traction because it was good enough. 

For more:

• How to protect your portfolio in a crisis.
• More on defensive asset allocation.
• An easy way to move to a 70-30 portfolio.
• Why you should use short-dated global index linked bonds hedged to the pound. Part one and part two.

High-quality government bonds means gilts or a developed market government bond fund hedged to the pound.

Taking control with a 60/40 portfolio

The more effective countermeasures you can take are technically simple but emotionally difficult.

You can’t control future asset returns. But you can control these mission-critical factors:

• Contribute more money to offset lower growth expectations.
• Increase your time horizon to benefit from compounding.
• Lower your financial target to make it easier to hit. That ultimately means living on less, if we’re talking retirement.

To see what a difference this makes, run your numbers in a calculator like Dinky Town’s Retirement Income Calculator.

Adjust contributions, income target, and time horizon to suit your circumstances. 

See how things look under a range of expected return scenarios. Try plugging in optimistic, pessimistic, and middling predictions.

For example, these expected return forecasts come from Vanguard:

• Optimistic: 4% (75th percentile)
• Mid-ground: 2.6% (Median outcome)
• Pessimistic: 1.2% (25th percentile)

Those are 10-year annualised expected returns for three alternative universes.

To turn those into real returns, I’ve subtracted an average annual inflation guesstimate of 2% from Vanguard’s nominal figures.2

Put the expected returns into the calculator’s rate of return field via the Investment returns, taxes, and inflation dropdown.

Periods of lower (higher) returns tend to be followed by higher (lower) returns. Accordingly, you can hope for improved growth beyond the next ten years. The Dinky Town calculator lets you play with that, too.

The three most powerful changes you can make are putting more money in, waiting a little longer, and lowering your income bar. 

They also save you from meddling with your 60/40 portfolio if that suits your risk tolerance. 

Not-so-great expectations

Multiple crises over the past 15 years have trapped us in an escape room with no easy way out.

I wish there was a clear answer to this puzzle but there isn’t.

Taking action now means short-term pain for long-term gain.

On the other hand, what if the next decade exceeds expectations?

Hallelujah! We’ll be better off than we thought – living on more or retiring earlier.

In conclusion: fingers crossed.

Take it steady,

The Accumulator

1. Duration is a measure of sensitivity to interest rate changes. [↩]
2. Real returns subtract inflation from your investment results. They’re therefore a more accurate portrayal of your capital growth in relation to purchasing power. [↩]

People get muddled when they think about their own home in financial terms. This extends to a repayment mortgage used to buy a property.

Mental accounting – also known as ‘bucketing’ – is what causes this discombobulation.

Fact is we tend to think about the value of money differently, depending on where it comes from and where it ends up.

Mental accounting involves putting money into different mental accounts – or buckets – as a crutch in our financial thinking.

Bucket or bouquet?

For example, a 40-something friend tells you they have “no savings”.

Worried, you make plans to run the London Marathon dressed as a muppet on their behalf.

But then you discover they’ve been paying into a pension for 20 years.

Your friend discounts this substantial pension asset, probably because it can’t be accessed for another couple of decades.

Ignoring a pension like this is a mental shortcut. And to be fair it’s true that your friend can’t get cash from their pension if the boiler blows up.

It might also be easier for them to mentally treat pension contributions from their salary as more like a tax than savings. Filing such payments under the same ‘Inevitable’ label as taxes may help them stay committed.

Perhaps the thought that they have no savings could motivate them to build an emergency fund, too.

But still, the statement dramatically misrepresents their true financial position.

If they genuinely had no savings they’d be on-course to rely solely on a state pension in retirement. They’d be well-advised to take action – yesterday.

Or maybe someone decides to work out how to split their saving between their ISAs and pension – perhaps with an eye on early retirement.

When they do their sums their pension assets will suddenly appear in a ‘Live and Very Real’ bucket in all their glory. Previously they were clouded in a mental fog of their own creation.

The property puzzle

My favourite example of dodgy mental accounting is how even financially literate people think the home they own is somehow not an asset or an investment.

You can strive for hours to illustrate with logic and counterfactuals that their home is most definitely an asset AND an investment.

But this is a mental wall that Fred Dibnah would struggle to blast through.

Again, such self-delusion can be helpful.

Maybe because they don’t think of it as an asset, most people don’t trade their property or fret about small price moves. That helps their own home become the best single investment the typical person ever makes.

That’s the case even though their thinking is wrong! Oh the irony.

Admittedly the situation with a repayment mortgage is a bit more subtle.

Save your repayment mortgage

I was reminded of the confusion about repayment mortgages by comments on The Treasurer’s recent article on the savings rate.

Many – perhaps most – people tend to think of a repayment mortgage as a monthly expense.

They know they will own their home outright at the end of the mortgage term. (Weirdly even then most won’t consider it an asset. Harrumph!)

But along the way they see mortgage repayments as an expense that they mentally bucket just as they would rent.

They therefore don’t consider their repayment mortgage to contribute to their savings rate.

However repaying a mortgage is a very different proposition to paying rent, at least from the perspective of the person living in the house (as opposed to any landlord in the mix).

That’s because your monthly repayment mortgage direct debit consists of two parts.

• One part sees you pay interest you owe to the bank for lending you the money (via your repayment mortgage) to buy a home in the first place.

• The other part involves paying off some of the outstanding loan. These are the payments that will eventually reduce your mortgage debt to zero, and see you own the property outright.

The following graphic from our repayment calculator breaks down these two parts of a repayment mortgage:

This shows a £100,000 repayment mortgage charging 3% paid down over 25 years.

You can see how in the early years you’re paying off more interest than capital. Towards the end though, capital repayment – effectively savings – makes up most of the payment to your bank.

Cutting the expense account

Strip out the mental accounting, and the two components of your monthly mortgage payment are two different kinds of money transfer:

• The interest payments are an expense. They are the cost of having a mortgage.

• The capital repayments that reduce your outstanding mortgage are savings. They reduce your debt and increase your net worth.

Incidentally, to nip another bit of mental accounting in the bud, the market value of your house as prices fluctuate has nothing to do with any of this.

Your house is an asset and an investment that is worth whatever someone will pay for it.

This is true however you financed it – with cash, an interest-only mortgage, a repayment mortgage, or by blackmailing the previous owner with saucy photos extracted in a sting operation involving a sex worker with a knack for hidden cameras.

Your repayment mortgage in contrast is a debt that you are paying off over time. Nothing more and nothing less.

Same difference

Still not convinced? Let’s illustrate further by thinking about someone like me who has an interest-only mortgage, rather than a repayment job.

As the name indicates, every month with my interest-only I pay interest (only…) to the bank.

I am not repaying any of the outstanding loan.

Don’t worry, my bank is well aware of this! The deal is I’ll repay all the debt I owe in a couple of decades time. Until then, I simply pay the interest.

For the sake of argument, let’s simplify and imagine I have a £100,000 interest-only mortgage as well as £10,000 in a cash savings account.

My situation:

• Cash savings: £10,000
• Interest-only mortgage: -£100,000
• Balance: -£90,000

Now let’s imagine Monevator wins a prize for Most Waffley But Charming Financial Blog of the Year. Along with the bronze gong that I ship to my co-blogger because I hate clutter, I get £10,000 sent to my current account.

Let’s say I have just two choices as to what to do with this £10,000. (I’m too boring sensible to spend it on bubbly and financially loose playmates).

I could put the £10,000 into my savings account.

Alternatively, I could make a one-off payment to my bank to reduce my outstanding mortgage.

In the first scenario, I add £10,000 to savings:

• Cash savings: £20,000
• Interest-only mortgage: -£100,000
• Balance: -£80,000

In the second scenario, I make a £10,000 payment to reduce my mortgage:

• Cash savings: £10,000
• Interest-only mortgage: -£90,000
• Balance: -£80,000

As you can see can see, in both instances I end up with a negative balance of £80,000.

Indeed you can think of an outstanding mortgage as a savings account that starts deeply in a hole. As you save money by repaying your mortgage, you move this ‘negative savings account’ towards breakeven.

Save as you go with a repayment mortgage

How you think about a repayment mortgage is not just pedantry. It can sway the financial decisions you make.

For example, if you think of a repayment mortgage balance as another form of savings account, then you can compare the interest rates between it and your conventional cash savings accounts.

Say your mortgage charges 2.5% and your cash savings pay 0.5%.

You don’t need a calculator to see that on those numbers you’re better off paying down your mortgage with any spare cash allocated towards savings.

On the other hand, a mortgage repayment locks your money away. (Unless you have an accessible offset mortgage, which makes explicit the link between savings and mortgage repayments).

Remembering this you might not make a mortgage repayment with that cash windfall, because you want to bolster your emergency fund instead.

Of course, this being Monevator many of you will be thinking you’d invest any spare cash into the stock market.

And of course that’s an option – but it’s a different kind of saving.

Like your own property (and as opposed to your mortgage), an index fund, say, is an asset and investment. Treat it accordingly.

Happy saving!

What caught my eye this week.

Josh Brown is concerned. The financial advisor and TV pundit behind The Reformed Broker blog sees a new kind of fear and greed out there:

The type of fear that now drives most market activity (because it drives most market participants) is something different than the fear we’ve been accustomed to from reading about history.

I would label this type of fear Insecurity. The fear of being left behind and looking like a fool.

Every couple of years Josh – a hyper-connected poet of the markets – sticks a pin on the tail of the donkey of our times.

I think he’s done it again.

Sonic boom boy

It’s true a strange new operating system is running the show these days.

If you spend the unhealthy amount of time that I do taking skin burns from exposure to market radiation, you see it in everything from fallen hedge fund titans bemoaning day-trading nihilists to the world’s best banker getting befuddled about Bitcoin to meme stock madness and the endless back-and-forth shouting of crypto and story stock tribalists.

Not even the purist passive investor can completely duck the fallout. Monevator’s voice of sanity, my co-blogger The Accumulator, has written candidly about his own brush with FOMO:

How do you respond when someone invents something fundamentally new (hello, crypto) that could be a game-changer or a ponzi scheme? […]

If you’re The Accumulator you sit on the sidelines like a hunter-gatherer who can’t believe this farming lark will ever catch on.

Meanwhile, you torture yourself with crypto-millionaire fables – because even a caveman has to have a hobby.

Of course @TA is too chaste to be possessed by the zeitgeist. Instead he just gets the odd hot flush wondering about what might have been if he’d only acted a little crazy, like everyone else.

Boom Shack-A-Lak

Are we at a crescendo of craziness? A decade of gains in the dominant US market has sent its equity valuations into thin air. Meanwhile bonds look priced to do nothing more than fleece your pockets behind your back.

Perhaps we didn’t need overnight crypto billionaires, zero-cost stock trading, and a global pandemic that locked us in front of our computers to whip up this frenzy. But we got all that and more.

No wonder there’s a bit of a riot going on.

There will come a time when all this has passed. The thing to be seen doing will be to shuffle through the virtual town square bemoaning disruptive growth stocks, calling cash king, and flagellating yourself for claiming to have understood how Bitcoin works. Everyone will say never again and some will even mean it.

Eventually memories will die and a few on the fringes will hear a new beat. But that’s a story for another day.

First, last, and always

Indeed I don’t think today’s climate is unprecedented – batshit bonkers though it may feel at times.

It reminds me very strongly of the late 1990s and the Dotcom boom.

I sat that out as an investor. But I was in the mix as a recent-ish graduate with a tech background and exposure to people getting rich quick:

Visiting an old friend at the company, I was amazed to see that many of these formerly artistic types, from the secretaries to my friend in management – now had shortcuts to stock tickers on their desktops.

They were entranced to see themselves become richer by the day  and they watched their share prices like parents cooing over a new baby.

Now let’s be clear: I don’t think we’re in an identical tech bubble right now.

The best companies today really are technology firms. They’re flush with cash and their profits are still galloping higher in a way that textbooks said was near-impossible.

I talked about this reversal on Monevator many years ago. Even today my active portfolio has more in tech than will probably seem wise in retrospect. The shares are expensive, but the companies are genuinely changing world.

No, it’s more that desperate edge to the missing out that Josh identifies that reminds me of the late 1990s.

Your investments are going up, but someone else’s are very publicly doing so at light speed. And that guy you knew from college is already a millionaire on TV. (Or more likely YouTube or TikTok nowadays).

Don’t stop ’til you get enough

Here’s a tiny anecdote from the Dotcom boom that seemed like a bad dream just a few years later, when the West was bogged down in a war in Iraq and we were 36 months into a bear market.

The scene is a beer garden with a couple of mates in West London in 1999. There I am making the case – again – for us quitting our jobs and starting a tech firm.

We’d been in the right place at the right time for what seemed like an eternal four or five years. And everyone was getting rich except us – but that wasn’t actually the worst of it.

No, what I remember feeling was exactly the existential insecurity that Josh talks about in his piece.

It wasn’t so much that there were big opportunities to make money that we felt we were missing out on.

It was a dread sense that this might be the last chance to get ourselves out of the doldrums and into the class of wealth generators apparently being airlifted to a new economy all around us.

History tells us the feeling was mostly nonsense. Lots of those paper fortunes evaporated. I knew founders who were back in a day job by 2001 and I wasn’t even especially startup-adjacent.

But the future didn’t feel like that in that pub in 1999. It was now or never.

Maybe the Dotcom boom was more localized than today’s global mania, which is why I feel this callback where Josh doesn’t.

Do I have antibodies lingering from those times? I hope so!

Okay boom-er

I’m not silly enough to predict an imminent crash. Markets can stay bananas for ages.

But this graphic from John Authers at Bloomberg shows we’re all-in on this together:

If this is your first time around the block, know that markets are bewitchingly cyclical. The next bear market will begin the day most people have forgotten they ever happen.

Enjoy the boom while it lasts, but have a plan or an asset allocation ready for the day when it’s done. (As a very active investor my plan is basically to run for the exits when the time comes before everyone else. I strongly you suggest you have a more sensible one!)

The important thing in the investing game is to keep compounding over the decades. It all adds up eventually. Never risk getting wiped out.

Meanwhile if this is not your first rodeo then you don’t need me to remind you these best of times won’t juice our returns forever.

Except, of course, you probably do…

Have a great weekend!

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