George Santayana once said, “Those who cannot remember the past are condemned to repeat it.” Santayana was thinking about moral philosophy of course, but his comment is applicable to your retirement system, as well. Let me explain.
I recently had a visit from some a nice couple from East Sandwich; I’ll call them Jay and Collette. Jay and Collette, like me, both just turned 50 last year. They have one kid off to college in the fall and another who’s a junior at Sandwich High. These two hard-working professionals have been managing their investable assets themselves and are concerned about their strategy. Their assets took a bit of a beating shortly before our meeting. Jay said that he did not understand what they did wrong. He and Collette thought they were relatively safe from market corrections, but were looking at some pretty hefty losses in their portfolio. They decided it would be a good time to have their portfolio reviewed by a retirement specialist.
When I dove into the details one thing became apparent right away: they were following an outdated formula.
You see, for decades many retail financial professionals and stockbrokers recommended a 60/40 portfolio to their clients – a split comprised of 60% equities and 40% bonds, or other fixed-income instruments. So, Jay and Collette decided to use that same formula.
The conventional wisdom has been that investing 60% of a portfolio in stocks (equities) would provide market gains while allocating 40% of a portfolio to fixed-income instruments, like bonds, would provide some yield and help to cushion that portfolio from market downturns. The logic is that if stocks go up, bonds go down. And vice versa. Or another way to put it is that those asset classes are uncorrelated.
Hmmm . . . but what if they are not?
Since 2000, there have been periods when stocks and bonds have both moved downward simultaneously. Which is exactly what happened right before Jay and Collette came to see me. These sorts of double-downward shifts can be short-term, but the bottom line here is that “conventional wisdom” isn’t gospel and needs to be reevaluated in part because the correlation between many asset classes has increased.
The 60/40 strategy is a point of confusion to a lot of investors. A Dreyfus analysis published in 2017 showed that 42% of individual investors thought the ratio was a strategy for short-term and long-term investments (it isn’t – again, it’s equities and bonds). Once the strategy was explained to those investors, only about half of those polled thought it was the ideal asset allocation.
Here’s the problem: with such an uneven economic recovery, low rates at central banks worldwide and other factors, a 60/40 portfolio simply doesn’t make sense for many investors. Bonds no longer post returns at the rates they did when this formula was first developed and are unlikely to get close to that level again anytime soon. And at the same time, they are still subject to interest rate risk and market risk. Although fixed-income investments can be an important piece of an individual investor’s portfolio, it is critical to understand how they behave and to consider whether the amount allocated to such investments is appropriate for the defined risk tolerance and investment goals.
In fact, there are alternatives to bonds that may offer higher yields while still cushioning a portfolio from downside risk. And as I frequently say, it is also important to have a rules-based system in place to take advantage of upward market movement while limiting volatility when the momentum on Wall Street shifts.
Jay and Collette are still in the wealth accumulation phase of their lives. They’re years – decades, probably – away from retirement. But like many people their age (Gen Xers), they lost a significant amount of wealth in the 2008 recession and have worked very hard to make up for lost time. So, it’s perhaps understandable why Jay and Collette would take what they consider is a conservative position with their investment portfolio.
And although Jay and Collette have succeeded in rebuilding their wealth since 2008, they have not recalibrated their investment strategy. They are just as exposed in 2018 as they were a decade ago, when they lost 40% of their wealth – in spite of having such a large amount of their portfolio invested in an asset class with more conservative annual returns.
As Cutter Family Finance readers know, we should never look at an investment as right or wrong, only as appropriate or not. Even though Jay and Collette thought their existing investment strategy would cushion them in the event of a market downturn, the reality is that it left them open to losses – potentially big losses if the correlation between equities and bonds continues to increase.
What’s my point?
Look, we all need to be mindful of the changing nature of the financial markets and we cannot be afraid to reevaluate some of those well-known investment rules. We need to understand if and how those rules apply to us.
So, this week, ask yourself whether your current investment rules are appropriate in today’s markets . . . or not. Ask yourself what options you have available to you to help reach your goals. And this would certainly be a great time to understand the correlation between the asset classes in your investment portfolio.
Be vigilant and stay alert . . . because you deserve more.
Have a great week!
Jeff Cutter, CPA/PFS is President at Cutter Financial Group, LLC. A wealth management firm with offices is Falmouth, Duxbury, and Mansfield. Jeff can be reached at firstname.lastname@example.org.
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