Several years ago, concerns about so-called 60/40 portfolios began to grow in professional investment circles. It has since become clear that financial advisors should look beyond bonds to hedge stocks and boost client portfolios.
The 60/40 strategy involves investing a portfolio 60% in stocks and 40% in bonds. From that baseline, advisors have devised many different ways to drill down to specific asset classes and securities to fill that 60/40 mix. And, while the stock market's historic heights in price and valuation are certainly a concern for many financial advisors, there is a big difference between the situation with stocks and that of bonds.
Advisors expect volatility from stocks. The drops in the S&P 500 index of 20% in three weeks in 2018 and 33% in five weeks in 2020 showed the inherent volatility of equity investing. But volatility in the form of sudden, steep price drops in bonds? That's something that only investors from 40 or 50 years ago have seen before.
Bond rates have been falling for decades. But today, rates are much closer to zero than to the good old days of money markets yielding 4% and intermediate-term munis, corporates and Treasuries doubling that level or more.
This leaves today's advisor no further wiggle room. Do more than simply observe the dramatic changes to your clients' 40% in bonds. Be proactive in finding other ways to complement stock portfolios and find a new 40%. Here are a few tips on how to start that process.
If you are committed to devoting 60% to equities to drive long-term growth in your clients' portfolios, that is great. You would be doing them a disservice, however, if you didn't think hard about how to protect their total portfolio when that core equity segment falls on rough times.
This doesn't mean a bad day or even a bad month or quarter. Down markets in equities can erase years of gains, with no guarantee that they will be regained anytime soon. In addition, getting back to even in a bear market simply means there was a lot of time when you were paid but your clients didn't make any money.
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It was not too long ago, around the global financial crisis, that the S&P 500 index broke even across a 10-year period. Investor psychology is much more short-term than it was back then. So, don't expect to get paid for years if your clients suffer drawdowns that don't immediately recover. The reversals after the drops in 2018 and 2020 were fortunate. But it doesn't always happen that way.
How do you hedge? There are a wide variety of tactics, and it is best to think of them as being on a spectrum. The exchange-traded fund market is a good example. Some ETFs simply do the opposite of a broad stock market index, while others hedge against "tail risk," those sharp, dramatic sell-offs that seemingly come out of nowhere, yet were probably just the last straw in an overvalued market (like the one happening now).
Other hedging approaches are more about finding ways to offset equity market risk by owning asset types that do not zig and zag with the stock market. That is, they possess low correlation to the equity market. However, advisors need to be extremely careful not to be overwhelmed by media reports on investments that used to offer low correlation to stock portfolios but no longer do.
First on that list, not surprisingly, is bonds. Bonds are not the natural complement to stocks that they used to be. And that's not just U.S. Treasury bonds, but also corporate and junk bonds. In fact, the Federal Reserve has had to backstop them for about a year now. Municipals are now backed by an increasing number of localities that are having a tough time meeting their financial obligations.
Bottom line: Low rates for bonds are one problem. The intrinsic contents of what's in those bonds, and the risk they now represent, is another.
Gold and silver have been touted as hedging assets. There is some merit to creating a portfolio pie chart of nonequity asset classes reminiscent of "Wheel of Fortune," but that is just diversification for the sake of diversification. The same goes for other commodities, as well as different types of equities, such as non-U.S. stocks in developed and emerging markets, small caps and others.
Hedging techniques can help dampen volatility, but they may also shave off a slice of potential returns. This is often the case in long, enduring stock bull markets. For conservative clients in retirement or approaching that stage of their lives, this trade-off could be acceptable. After all, they have made their money, and the priority is avoiding big losses.
So while hedging can play an important role in a new, balanced portfolio that eschews major allocations to bonds, it may surprise you that a viable complement to that long-term, core equity portfolio is ... equities. That does not mean that you just say "what the heck" about the bond market's risks and pile that 40% into long-term stock holdings. Instead, think of this as a form of diversification. You are not allocating between stocks and bonds. You are allocating between stocks you own and stocks you "rent."
Again, the ETF market can make this a fluid process. You just need to have a process. Or find someone who does and learn from it. Either way, the mindset here is one that focuses on the realities of today's stock market. That is, market sectors, industries and themes come in and out of favor a lot faster than they used to. Frankly, so do many bond market segments.
It follows that if you have a systematic, risk-managed, disciplined and consistent way of seeking smaller gains over shorter time periods, that might be the most valuable hedge for your main portfolio of stocks or stock funds you own for the long term. This essentially takes any corner of the equity market available in ETF form and makes it a potential source of value in the short term.
Equity-income-focused financial advisors should recognize that the tech sector as well as high-growth, low-yield industries have increasingly behaved differently than high-yield stocks. So having a process that includes dipping your toe into that other pool might just get you some of the diversification your clients seek.
The markets have changed, and that demands a rethinking of the 60/40 mindset. That 40% of the portfolio is vitally important, and it plays many roles for your clients. However, it is highly unlikely that bonds are the one-stop solution for that segment. So start to identify and move forward with your "new 40."