Hallelujah! Merrill Lynch Announces The Death of 60/40
Lee Kranefuss, Founder and CEO of the Kranefuss Group (leekranefuss.com)
One of the most perplexing things in investing to me has always been the idea of the 60/40 portfolio. Why does it make sense? It doesn’t? Did it ever make sense in the past? I doubt it.
Having made this claim this claim for a few years now, I am glad to see Bank of America writing an obituary: 60/40 is dead. (see https://www.forbes.com/sites/robisbitts2/2019/10/18/bank-of-america-says-60-40-portfolios-are-dead-theyre-right/#58a0bd403991 )
To me 60/40 was always a rule-of-thumb with little logic. What makes it better than say, 70/30 or 50/50? I always thought it had about as much basis as the Three Little Bears: 50/50 seems to conservative (not warm enough), and 70/30 seem too risky (too hot). Baby bear found the happy medium: 60/40 is “just right”.
I have a bunch of objections to 60/40, in addition to the ones Bank of America points out. Given the computers and the data we have, we probably should have done the analysis and put 60/40 away on the shelves of economic history (along with overvalued Dutch tulip bulbs) quite a while ago.
Perhaps the strongest is that investors simply get something other than they expect. When I ask the average investor, “if you invest and rebalance yearly at 60/40, what percent of the stock market’s return do you capture?” Almost all answer “60%”.
You will each year. But you won’t in the long-run.
Why? Quite simply, let’s suppose the stock market delivers on average 10% a year, and long-term bonds 3%. And to make it easy, let’s assume the stock market doesn’t bounce around: it actually delivers 10% every one of those years.
Indeed, each year you will capture 60% of the market’s return. But over 40 years, if your portfolio had been invested 100% in stocks it would end up worth $4,526. But the 60/40 fund would be worth only $1,614. That’s not 60% of the stock market’s return; that’s only 36%.
Where did it go?
Every year when stocks beat bonds the portfolio became “unbalanced” at around 62/38, and the money manager dutifully sells off 2% of the stocks and puts them into low-yielding bonds, never to participate again in the stock market. And, if you do this in a taxable account it’s even worse – because each rebalance leads to paying capital gains that, too, will never be there to compound further. Yet, many managers do this rebalancing automatically. Why? So the first questions from the client isn’t “why is my 60/40 fund not at 60/40?”
Much of money management is not far ahead of where medicine was in medieval times. There are common practices and approaches, assumptions and beliefs, that come not from analyzing the numbers and doing the computations, but from received wisdom or “standard practice”. Many also come from not thinking at the portfolio level as a whole, especially when taxes are involved. For example, for a few that bother me most , see these posts from my blog: https://www.leekranefuss.com/2019/08/one-of-the-strongest-arguments-against-active-funds-is-due-to-taxes-at-the-portfolio-level/ and https://www.leekranefuss.com/2019/01/the-dumbest-question-in-investing/.
RIP 60/40.