Paul Winkler: Welcome. This is “The Investor Coaching Show.” This is Paul Winkler, along with Mr. Jim Wood talking about money and investing. Jim, someone has asked a question.
One of my old producers actually asked this question. Matt was one of my producers of the radio show in the early years, and he asked a question about an article in Morningstar.
Jim Wood: Well, it’s when you get a little bit of knowledge about something and it piques your curiosity. And you’re just like, “Well, this makes sense, and I want to know more about that.”
Factors in Building an Investment Portfolio
You build upon your knowledge, you start layering that foundation and bit by bit, you add to your knowledge and it just becomes more and more interesting.
PW: So the thing that was written about in Morningstar was about a 60/40 portfolio. There are different investment designs. The first factor you focus on when you’re putting together an investment portfolio is: How much do I have in stocks versus how much do I put in bonds?
Build upon your knowledge, and you will become more equipped for investing success.
And that’s the first factor. Another factor you look at is small companies versus large companies, then value versus growth.
Other factors are going to be more expense related. For example, momentum would be another factor that you might look at.
Then you have the issue of profitability factor and other things like that, which are not as important.
But the very most important factor to consider is how much in stocks versus bonds. That’s your starting point, and it will be driven by the time horizon.
So if I’ve got a long, long time before you’d like to use the money then you basically can be all equities.
Then if you’re getting close to retirement, you might go somewhere in the neighborhood of about 70%, 75% stocks as you’re 10 to 15 years before retirement. That’s just an example. It depends on the person.
Sometimes you’ll have a situation where the time horizon may be significantly shortened due to your health, for example. It could be your job situation. Maybe you’re working in a career field that could be shortened based on back issues, bodily breakdown issues, those types of things.
It varies. Don’t take anything I say as, “It’s always this way.”
So then you get closer to retirement and you’re going to be physically taking income. Usually 50% is the minimum on stocks when you’re taking in income.
And you can go up from there depending on how much income you’re taking and what your level of flexibility is. The typical pension mix is 60/40.
There’s a saying here, “Why is the 60/40 balanced portfolio not working in 2022?”
The original question was, “Can you elaborate and explain the validity of this article?”
Is the 60/40 Portfolio Working?
Yeah, I think the headline just bugs the tar out of me. Right? It is not working. And the idea is that, “Oh, it failed, and it’s a new paradigm. We’re in a new situation. Things are all different now.”
60/40 portfolios, if properly designed, will take into account the type of things that are happening right now.
And what they’re really referring to here is the idea that if interest rates go up, then stock prices go down or can go down.
So why would that be? Well, if companies have a lot of borrowed money, then their cost of doing business has gone up and that can hurt profitability in the short run, because that takes away from their earnings.
The other thing is, of course, people borrowing money to buy stuff. And we’ve been hearing about this recently.
What we were talking about last week is exactly what happened, which just goes to show that what we’re talking about is relevant.
Part of that is because if interest rates go up, then it reduces the demand for real estate, it reduces the demand for cars, it reduces the demand for anything you might think of that people would borrow money to buy.
Hence, if this happens, you can have an economic downturn. The other thing that happens is, of course, interest rates going up.
If interest rates go up, what happens is that existing bonds will drop in price.
JW: Absolutely. And then the longer term of the bond, the more drastic the drop is going to be. So 20- and 30-year bonds will take an enormous hit from not really a big rise in interest rates.
PW: If interest rates go up bonds can take a hit—and it’s even more dramatic if you have longer term bonds. That’s the reason we tend to keep the bond maturities shorter.
We don’t go in 10-year, 20-year, 30-year bonds. You can get a higher yield, and that is so often what gets people all confused is they think, “Well, I’m here to get a return on my investments, right?”
PW: No, you can’t ignore correlation. You can’t ignore how things move with each other and against each other. So that is why we want to keep the maturity shorter is because we don’t want these big movements of stocks and bonds together.
What Happened This Year?
But you can’t avoid it if you’re going to have intermediate maturity bonds. And that’s in essence, what happened this year.
This year both of them went down together. What’s happening is people now think, “Well, okay, then the 60/40 portfolio didn’t work.”
No, no, no, wait a minute. You miss one of the things, one of the elements in a 60/40 portfolio that was fine, which is cash.
Prior to this year, people would call me and ask why I would recommend that they put so much in cash in a 401(k) or IRA or non-qualified account or whatever other account.
“Why so much cash? I mean the interest rates are just about nothing,” they would ask. And I would say, “Yeah, the purpose of the cash is not return.”
You pretty much guarantee you’re going to lose money after inflation. But the key is that when stocks go down and if stocks, not even when, they will go down and if bonds go down with them, you have to have something you can pull income from. And hence the reason that we have cash in the portfolio.
JW: Well, the whole title of this, “The 60/40 doesn’t work anymore.” Well, there’s so much that is just wrong with that in terms of: Who says it didn’t work? Who says 60/40 specifically?
Maybe bonds did go down, whether you have short-term, long-term, or mid-term. We keep ours, like you said, very short, and so that did not go down nearly as much as stocks.
PW: Yeah. And cash actually held its own. It didn’t go down at all.
And that is the key. That’s something that I always teach at our initial workshops.
One of the keys to know whether your investment portfolio worked the way it should is: Did everything go down together?
So it did its job, it reduced some of the volatility. And that’s what it’s there for. Typically, it goes up when stocks go down, not all the time, because of rising interest rates and all that, but it still provided diversification benefits in that it did not go down as much.
Does Your Portfolio Hold Its Value Overall?
If it did, yes, that would be a failure. Or do you have something, in any given year, do you have something that held its value? If you had something that held value, then, by definition, it worked and that’s really the key.
So that’s what happened. If something held its value, you’re fine. Now cash held value.
It would be foolish to think that stocks and bonds couldn’t go down together. It would be foolish to hold any cash in the portfolio whatsoever, if that couldn’t happen.
Always look at what can happen when you’re designing an investment portfolio and recognize that what happened this year could happen.
And it does happen.
When you have that situation where interest rates go up dramatically in a short period of time, people borrow less to buy stuff, they can’t buy enough stuff or they can’t buy things that they used to buy or they’ll reduce their demand for those things, which will inevitably drive stocks down.
But here’s the thing about bonds. The other part about those bonds as well. When you keep the maturities a little bit shorter, that decline in bonds tends to be very, very short lived, tends to be very short lived. And what happens is that you’ll actually have a higher yield to maturity with those bonds when those bonds go down in value.
So actually the 60/40 portfolio worked quite well. Now here’s the thing that I hear from time to time from people. It is that the rule on how much income you can take from an investment portfolio doesn’t work anymore.
And I would absolutely have to agree with them. It didn’t work because of the way that Wall Street investment firms typically manage money. They typically chase returns.
They stock pick. They market time. They use tactical asset allocation. They use long term bonds in their investment portfolios. They overweight large US stocks. They do all of the things that for over 20 years on this show, I have said, “Don’t do that.”
And then what happened is then they go, “Oh, that rule of taking income from your portfolio doesn’t work anymore.” No, it doesn’t work if you don’t follow the dictates of the study that was done on how much income you can take from an investment portfolio.
The Market Is Always Different
Not that this bothers me at all. Not that I don’t need to go do deep breathing exercises right now after that.
But it just makes me crazy how you get stuff out there like that and people go, “Oh, it doesn’t work. Everything’s different now.” And I think that’s the key to it, Jim, for me, is that premise that it’s all different now.
It’s always different.
JW: Well, I think so much of financial journalism comes from the point of, “Okay, this headline sounds really neat. I’m going to write an article to go along with this headline.”
PW: Very true. It’s like, “What can we do to really shake things up, regardless of whether there’s any truth behind it, whether it’s helpful or not, let’s write something to shake people up.”
Then on the other side then you have the investment industry take an article like that and say, “See, it’s true,” because they’re trying to sell something and it backs what they’re trying to sell.
What they don’t recognize, a lot of times, is that because they don’t really analyze the data very well, they come to the wrong conclusions. Because they’re actually looking for what they need to sell.
And we call that confirmation bias. We look for things that tend to back whatever is the conclusion that we would like to draw for whatever reason.
We tend to do that as investors, but the sales community also does it, which makes it so, so difficult for the investor.
JW: And the thing about the 4% rule too, is that’s a place to start the conversation. That doesn’t mean everybody out there should take 4%.
It’s just a number they came up with when they did the initial study, so everybody ends up talking about that number. But everybody’s different in terms of what their savings are, what their needs are, and those types of things.
Every investor is different in terms of what their individual needs and circumstances are.
So it’s really a place to start talking about the situation. And we have some phenomenal software in terms of helping people figure out what is the right amount to take income from in terms of it being a dynamic process.
Meaning as long as you can be a little flexible, if markets go up, you can take a little more.
Don’t Let Yourself Be Misled
PW: You can take even more than that. Yeah, that’s exactly right. So that number, that 4% was the amount that you could take going back and using data from the year 1900. So of course you’re actually looking at the Great Depression, World War II, the Korean War, and the Vietnam War.
You’re looking at everything that has happened, oil crisis, real estate crashes, tech crashes, and so on. That’s what William Bengen, the gentleman that did the research on this, was looking for.
He looked at what level of stocks versus bonds a person needs in order to take an income? What gives the optimal ability to be protected from inflation for at least a 30-year period?
JW: I wish I could remember the study, but there was one that looked at the 4% rule going through the crash of 2008. And turned out, yeah, things were unpleasant for 15 months, like they were for everybody, but ultimately that person did fine, when looking at that portfolio.
I wish I had something to cite on that.
PW: Well, we have it in some of the things that we’ve done for our clients that we’ve done workshops on that particular topic even. And, yeah it worked just fine during that period of time.
So the reality of it was, and just as far as where that data is and that if you’re a client of ours, we can direct you to that where we actually went through that whole process.
There have been studies done out there. Yeah, it’d be kind of neat to find where somebody else other than ourselves actually showed that was the case.
The educated investor is not easily misled.
But anyway we hear that and just recognize that so often what happens as investors is that people are being sold things and not necessarily with all of the real facts being used in order to help sell investment products.
Be very, very careful. That is why I spend so much time, and we spend so much time, right here on this show educating because I believe the educated investor is not easily misled.
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