The 60/40 portfolio is a popular investment strategy, but there’s a lot of debate about its main goal. Is it to spread out your investments (diversification) or to keep your money safer (risk reduction)? These two things are related, but they’re not exactly the same.
No one is really into the idea of a one-size-fits-all approach to investing. It’s good to keep things simple, but what works for one person might not work for another. Everyone has their own comfort level when it comes to risk and reward, and many common investment strategies don’t really consider these personal details. This is especially important when it comes to building an investing portfolio that aligns with your unique financial goals and risk tolerance.
How Does Diversification Work in the 60/40 Model?
So, are you ready to explore and talk about the 60/40 strategy? It’s been a key part of building an investing portfolio for many people over the years, even though it’s also faced a lot of criticism. Basically, with this strategy, you allocate 60% of your portfolio to stocks and 40% to bonds. Last year, this mix didn’t perform as well as expected. But that might have just been a temporary setback, and the situation could improve if investors stay patient.
The big question is: how do you decide if the 60/40 strategy is working? The problem is that its goals aren’t very clear. With interest rates going up, everyone is in for some unpredictable times in the market. Strategies that aren’t clear from the get-go are likely to struggle.
The 60/40 plan comes from an idea by Harry Markowitz, who won a Nobel Prize for his work on modern portfolio theory. But, even though his theory is over 70 years old, it doesn’t specifically mention this 60/40 split. Still, many financial experts recommend it as a great balance between risk and return.
But this simplicity can be misleading. For the 60% in stocks, it’s not clear whether you should go global for more variety or stick mainly to U.S. stocks, which is what a lot of big funds do. And in the past few decades, when people say the 60/40 did great, they’re usually talking about funds that focused on U.S. stocks.
What Role Do Bonds Play in the 60/40 Investment Mix?
The bond part, the 40%, is even more confusing. Should these bonds be super safe to balance out the riskier stocks, or should they be a mix, including some riskier ones, for diversification? These two approaches – going safe or diversifying – are different and need different types of bonds.
What’s popular in most funds seems to be diversification, with a mix of riskier and longer-term bonds. But this might be because safer bonds weren’t giving much return, and some people didn’t fully grasp the risks with long-term bonds, especially with inflation on the horizon.
Knowing if you prefer safety (hedging) or variety (diversification) helps you measure success. If you want a fund that keeps its value no matter what, then safer bonds should be your go-to, and big drops in value are a problem. But if you’re okay with a mix that might have big drops now and then but generally does well, diversification is your strategy. In this case, remember that 60/40 isn’t the whole game; you might need to add some of your own safety measures.
The 60/40 approach can try to do a bit of both – diversification and safety – but it’s important to be clear about what ‘safety’ means and to include it properly in your bond strategy.
Keeping investment simple has its perks. Sticking with the 60/40 mix might be a smarter choice than many other strategies, especially if the fees aren’t too high, because it does offer a straightforward way to diversify. However, with changes in the bond market and the chance of an economic downturn, it wouldn’t hurt to tweak the 60/40 strategy a bit – starting with being clearer about what it’s trying to achieve.