The Investment Scientist

How not to ruin a 60/40 portfolio

Posted on: January 6, 2010

This past Christmas, I had the distinct pleasure of calling several of my clients in retirement and telling them their portfolios are back to their pre-crisis level and their financial freedom is safe and sound.

Their portfolios are variations of the so-called 60/40 portfolio – about 60% in equity-like investments and 40% in bond-like ones.

icarra chart

Many other 60/40 portfolios have been decimated by this crisis. Even with recent gains, they are still far from recovering all their losses. How did I manage to pull even for my clients? There are a few key lessons I’d like to share.

Prescience is not required

There are financial advisors who claim they saw the crisis coming and moved their clients’ money into cash before sh*t hit the fan. I am not one of them. Though I did see storm clouds gathering, I underestimated the severity and stuck with their original investment plans through the crisis.

Get my white paper: The Informed Investor: 5 Key Concepts for Financial Success.

Keep the bond section pure

One of the biggest reason that many 60/40 portfolios took a big hit was that the bond portions were filled with higher yielding corporate bonds, even junk bonds.

Fama and French, in their research paper “Common Risk Factors in the Returns of Stocks and Bonds,” documented that term risk and credit (default) risk are not sufficiently compensated by the market. In laymen’s term, those risks are not worth taking.

Many financial advisors, however, like to put investors’ money in higher yielding bonds since the additional 1% in yield  is great for marketing, Little did investors realize that for that additional 1% in yield during good times, they would suffer 40% in losses during bad ones.

I put my clients’ bond portion mostly in short-term Treasuries; during the depth of the crisis when all other types of bonds fell by 30% to 40%, they rallied by 8% to 10%.

Rebalance religiously

At the beginning of 2009, I was able to reallocate the stronger bond portion to the much weaker equity portion just in time to catch the equity rally that followed. It is easy to recount now, but at the time when the market was permeated with fear, it took a written plan and steely commitment to it to excecute the rebalancing.

If you want to make sure that the bond portion of your portfolio is strong enough to provide protection during bad times, order my Portfolio Review service.

Get my white paper: The Informed Investor: 5 Key Concepts for Financial Success.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



You may also get his monthly newsletter, or join his Facebook page for regular wealth management insights. Michael's email is info[at]mzcap.com.

Twitter: @mzhuang

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