Faulty Assumptions Underlying Everything You Believe

...about portfolio construction and sustainability.

Look at this table from Charlie Bilello:

 

Have you ever looked at past results from a 60/40 equities fixed income portfolio and been impressed or at least favorably disposed? How about the 4% rule which we've looked at hundreds of times? The data supporting 60/40 and the 4% rule includes eight years in the last 40 with double digit returns for bonds plus a couple of more 9.7's thrown in. 

Do you think it's a good bet that for the next 40 years, there will be double digit gains from the bond market 20% of the time? With the state of negative yields elsewhere, I won't say it is literally impossible but pretty much impossible. 

That means 60/40 returns won't be as good as any historical data you might look at. It also quantifies something we've been talking about for a while which is that the 4% rule is based on a 40% allocation to bonds getting a yield that no longer exists as well as a total return potential that no longer exists. 

Could equities make the difference? On a continuum of probability, I would say where bonds are much closer to the literally not possible end of the spectrum, equities are more like maybe they will maybe they won't. There's no zero bound, if that even is a bound, confronting equities. Stocks are expensive by almost any measure but there's nothing to say they can't get more expensive, there's nothing that says they can't just stay this expensive or grow into their current valuations. It could absolutely play out that way, just understand that equity markets are on weak fundamental footing which increases the potential for the bad kind of volatility. 

Where bonds are often held to offset stock market volatility, then long dated bonds, if anything could exacerbate stock market volatility. If and when interest rates go up, intermediate and long dated fixed income products will get crushed, price-wise. I have no idea if rates will go up a lot but the risk is clear, rates are close to all time lows with inflation running hot and a central bank that is signaling rate hikes are coming. I've owned no long dated debt for clients for many years, I've avoided interest rate risk for years because it has been prevalent for years. It's much easier to avoid that risk and seek out yield and fixed income exposure in other sectors like bank loans, short dated high yield, short dated TIPS and strategy funds with long term track records of delivering "normal bond market like" returns as some long/short funds do. 

If your goal with fixed income is managing equity volatility, you can do this with products that bring down the equity beta (the extent to which your portfolio tracks the some broad equity index) of your portfolio pretty easily. Things like gold, inverse funds, different long/short funds than mentioned above will offset a portion of the beta derived from your equity holdings. If you put 90% of your money into an S&P 500 fund and 10% into a double inverse index fund, you might expect that everything else being equal, your beta could be around 70 which is not that far from 60 as in 60/40. Hopefully, no one reading this is crazy enough to build a 90/10 portfolio in the way I just described. It's a building block of understanding, an example to show how beta reduction potentially works. Part of the crazy of that 90/10 blend is the phrase "everything else being equal." That's not how the world works.

I've had several clients who over the last year or so reach out to change their portfolio to do something similar, reduce they extent to which they are exposed to equity market volatility. I think this can work. You won't be up 30% when the stock market is up 30% but I think there is great chance of not being down anywhere near 30% when the stock market goes down by that much. If you feel a sense of game over because you have enough money and you probably no longer have a 50 year time horizon, this can make sense and so you can have a larger portion than 60% in equity-like exposure with a less than .6 beta to the market. Using the right products, you could have 75% in equity like products with a beta that is half the market's and have much easier time avoiding interest rate risk that might be embedded in the typical 60/40 portfolio. 

As far as workarounds for the 4% rule, we discuss that all the time here but everything I've ever suggested on this topic could be summed up by saying "figure out how to be less dependent on your portfolio for income." Ideas here include when you're younger investing in something that gives passive income, monetize a hobby, get some sort of other fun part time job, downsize and so on. 

Retirement is something to solve in an individual manner suited to your preferences, resources, quirks (we all have them) and the limits of your ability. I think things like 60/40 and the 4% are great building blocks to get started but there's a good chance you'll have to adjust those building blocks to your particulars so be engaged enough to understand the building blocks and what you need to do with them in order to succeed.