Your Stock Portfolio Could Doom You in the Next Recession

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Those who love Wall Street investment products tout the average annual return of 9.5% for the S&P Index over the past 20 years as a reason to invest in public equities. However, the 9.5% figure doesn’t paint the entire picture because that 20-year average doesn’t account for volatility.

For example, in 2017, the S&P 500’s total return was over 19.7%, but for 2018, it was minus 6.2%. What the pro-Wall Street crowd won’t mention is that to compensate for volatility, bonds are usually thrown in the mix as a hedge against downturns like in 2018.

Bond yields have been at historic lows so when comparing Wall Street products to other investment classes it would be more accurate to compare the returns of a mixed portfolio allocated to both stocks and bonds since very few Wall Street-centric portfolios are 100% dedicated stocks.

Of all the portfolio allocation strategies adopted by Wall Street, none is more popular or more widely used than the 60/40 model.

The classic 60/40 portfolio allocation strategy, which allocates assets between stocks and bonds 60/40, is a conventional approach to allocation, but it’s also outdated and, in the current economic climate, we dare even go as far to say, dangerous.

The 40-year-old 60/40 rule was created when bond yields averaged 8% and the stock market 12%. However, with the average bond yield at 1.6% for the last 10 years, this strategy no longer works. If your financial advisor has you in a 60/40 allocation mix, you may want to rethink continuing to use him as you may be in trouble when the next recession hits.

Back in the day (the early 80’s), the thinking was that bonds provided protection in a crash where stock prices fall and bond prices generally rise. That’s when bond yields averaged more than 10% and the S&P 500 12%. The 60/40 allocation assumes that when stocks have a bad year, bonds will pick up the slack and move in the opposite direction.

But, what happens when stock prices and bond prices both have bad years?

In that case, bonds no longer offer protection. There is evidence for this trend. The early part of 2018 is reflective of what may be happening more and more in the future – bond prices and stock prices moving in the same direction, especially during periods of downside volatility.

In February of 2018, the S&P 500 fell slightly more than 10% from its highs set on January 26th, at the same time bonds sold off. Without its inflation-hedging benefits, in today’s low-yield environment, bonds are pretty much dead weight in terms of portfolio performance and drag down the portfolio in boom years.

What was Wall Street really trying to accomplish with the 60/40 Rule? At its most basic, the 60/40 Rule was designed to provide decent returns during good times through stocks while hedging with bonds during downturns. However, in today’s economy, the dead weight of bond yields (1.6% average in the past 10 years) is the primary reason the 60/40 rule may no longer work.

The idea was that the 60/40 rule offered diversification, but bond yields moving in the same direction as stocks defeat this purpose.

The dead weight of bond yields also hinders investors from amassing the type of nest egg required because now they are expected to live longer lives. Because people are living longer, they will need more income to last their entire retirements.

Inadequate income is problematic because as inflation rises, so will expenses when people are in retirement. Returns from a 60/40 mix may not be able to keep up with inflation. That could reduce investors’ purchasing power once they’re ready to retire.

The times have changed, making the 60/40 rule obsolete, but why do financial advisors cling to it?

For one, it’s simple. 60% in stocks, 40% in bonds. What could be easier? Two, it’s lucrative. With commissions tied to stocks and bonds, the liquidity of stocks and bonds allows for fee churning.

For investors seeking the benefits the 60/40 Rule provided 30 years ago, including high annual returns, a hedge against inflation and diversity, I’d argue that another allocation strategy is more fitting in today’s financial climate – one with a majority allocation in alternatives investments.

An investment portfolio heavily weighted towards alternative investments like real estate accomplishes all of the objectives the 60/40 rule used to achieve.

Yield? Check.
Downturn Hedge? Check.
Diversity? Check.

Alternative investments, including private equity, commodities, and real estate, offer a variety of asset classes and investment structures, ideal for spreading risk.

A portfolio heavily weighted with stocks and bonds could spell trouble in the next recession. Don’t get caught by surprise during the next downturn. If you’re invested in public equities and bonds, you may want to rethink your strategy. The stock/bonds mix no longer makes sense for yield, diversity and as a hedge against downturns because bonds no longer offer downturn protection due to low yields.

For above-market returns and a hedge against recession, alternative investments like commercial real estate offer the best of both worlds.

The 20-year return on real estate has averaged 10.6% while a 60/40 mix of stocks and bonds would have returned an average of 7.32%. Alternative investments like real estate offer far superior returns while also protecting against downturns since alternatives have low correlation to the broader markets.

For information on investment opportunities to protect yourself from the next downturn, check out our alternative investment funds for superior risk-adjusted returns.