Balance is key to your investment survival
The decline in interest rates to ultra low levels may cause you to wonder whether it is time to switch some of your investment money from fixed income to stocks.
Many experts advise investors to consider it under the right circumstances.
But don’t do it lightly. Upping equity exposure can make sense for some investors, but it adds risk and could be a big mistake for others.
Finding the right asset allocation is personal and will vary by individual. But historically, a mix of 60 per cent equity and 40 per cent fixed income (a “60/40” mix) has long been considered the “centre of gravity” for investing long-term, as termed by financial historian Peter Bernstein in a famous article written in 2002 titled “The 60/40 Solution.”
But with interest rates so low, many experts argue that the asset mix centre of gravity has shifted. “75/25 is the new 60/40,” is the catchphrase endorsed in recent interviews by finance professor Jeremy Siegel, author of “Stocks for the Long Run.” And Siegel is not alone. “The 60/40 mix is pretty much under siege in the industry literature,” says Tom Bradley, chair of Steadyhand Investment Funds. “I see an article every week or two that is pointing out the 40 per cent (in fixed income) is earning one per cent, maybe up to two per cent if you take some risk,” says Bradley. “60/40 has actually served people quite well. But Jeremy and others are right to question what works well going forward.”
However, loading up on equities isn’t a wise move for everyone.
“Too many people are going all equities — or going from 60/40 to 75/25 — without really thinking about the consequences,” says Bradley.
We discuss circumstances below when adding equity makes sense and when it doesn’t.
Balancing risk and reward In large part, your long-term asset allocation should depend on your optimal tradeoff between expected returns and risk.
Stocks provide higher expected returns over the long term, but come with the risk of substantial losses over shorter intervals. Unfortunately, you can’t reliably predict the timing, depth and length of these down periods.
While it’s uncommon for stocks to lose money over longer intervals of 10 years or more, it has happened periodically. For example, from the beginning of 2000, it took about 11 years for the S&P 500 Index of large-capitalization U.S. stocks to recover in terms of total returns from the combined impacts of the tech bubble collapse and then the Great Financial Crisis. Patience usually rewards equity investors in the end, but sometimes a great deal of patience is required.
Relatively safe forms of fixed income like investment grade bonds and government-insured GICs traditionally provided moderate expected returns and helped stabilize your portfolio when stocks suffered during periodic downturns. With ultralow interest rates now, expected returns from fixed income are almost negligible. But relatively safe forms of fixed income are still by far the most reliable source of stability for your portfolio. That should count for a lot given the great uncertainty about how the pandemic will play out, what the path to economic recovery will be, and how stock markets will respond.
It’s important to test whatever asset allocation you’re considering against adverse conditions. It’s easy for investors to think they have already aced the test when they stayed the course during the sharp market meltdown in March. But as stock downturns go, that one was unusually brief. So a more stringent test would be, not what happened in March, but what could happen with another steep downturn in stocks that lasts far longer with a much more gradual and extended recovery.
Your inherent capability to withstand such tests is indicated by your over-all risk tolerance. It is important to realize that over-all risk tolerance depends both on your willingness and your ability to take on risk. It incorporates both attitude-related behaviour and capacity for risk based on circumstance.
If you invest in stocks, you should invest for the long term and be willing to stay the course with investments during market downturns (and ideally rebalance). If you lack the fortitude to stay the course, you’re unlikely to achieve the higher long term returns from stocks that you expect. “If you go much heavier with equities and then bail out when it’s not working — you’ve lost all the benefit and probably more,” says Bradley.
But a stay-the-course resolve by itself is not enough. You also need to ensure you have sufficient ability to take on risk, so you’re not forced by circumstances to sell off stocks at the wrong time when they’re down.
If you’re in the prime of your working life investing for the long term with a secure job and are undeterred by market gyrations, then you might have both a willingness and ability to assume considerable risk. If you loaded up on stocks, your portfolio would suffer severely at the onset of a stock downturn, but you could apply a continuing flow of new savings to purchase more shares at attractive prices. If the stock slump lasts several years, that allows you to buy a lot of stock cheaply. Your portfolio would then be well-positioned to rebound if you can patiently wait for the next bull market.
If that describes your situation, you might well suit a stock-heavy asset mix like 75/25 or something similar. On the other hand, if you’re unable or unwilling to embrace the extra risk, stick with 60/40 or something else with more fixed income.
Retirees are usually in a different situation compared to mid-career investors. For starters, retirees usually don’t have means to replenish a portfolio with new savings should it be depleted by mishap. That means retirees usually have a more cautious willingness to assume stock market risk.
In addition, retirees often depend on cash flow from their portfolios to generate money to live on, which tends to result in reduced ability to take on risk. If you’re loaded up with stocks and you experience a market meltdown near the start of retirement that lasts for a few years, then having to continually sell stocks at beaten down prices to support yourself could have severe consequences. That could deplete your portfolio pretty heavily so you don’t benefit nearly as much when the recovery in stock prices eventually occurs. In that case, it makes sense to ensure that you have enough fixed income to cover withdrawal needs during an extended bear market in stocks, so stocks can recover undisturbed.
Just how much fixed income you will need will depend on many factors, but you won’t want to scrimp. In my view, an asset allocation of between 50/50 and 60/40 generally makes sense for typical retirees with moderate risk tolerance investing for the long term with a continuing need to draw on their portfolios to support themselves. If you’re wealthy or have living needs covered by a generous employer pension, then you might suit a little more equity. On the other hand, if you want to play it safe and are willing to accept more anemic expected returns, then less equity might be appropriate.
Another point to consider: Make sure you’re not taking more risk than you realize with your fixed income investments, says Bradley. Many investors searching for yield have loaded up on riskier forms of fixed income like highyield bonds, he notes. Unfortunately, higher-risk fixed income tends to sell off similar to equities during stock market downturns, thus providing little or no stabilizing power when you need it most. “If you have taken that 40 per cent (in fixed income) and dialled it up (with riskier investments), then you’ve effectively already taken your equity content higher,” says Bradley.
Bottom line The 60/40 mix isn’t necessarily supplanted as the “centre of gravity” for setting your asset allocation, but how gravity pulls on your portfolio works a little differently with ultra low interest rates.
You can’t expect to earn as much return from fixed income as you once could, but neither can you afford to compensate by taking on more risk than you can handle. Whatever asset allocation you go with, it’s important you find the right balance of risk and expected returns that works best for you.