Rethinking the 60/40 investing rule

stacks of pennies

The 60/40 investing rule is one of those long-held canons of personal finance.

The rule says you should have 60% of your portfolio in stocks and 40% in bonds.

It is typically referred to as a "balanced" allocation and is designed to offer you protection in times of market volatility. You're essentially using your stake in bonds as a hedge against the ups and downs of the stock market.

That's because bonds have been historically lower-yielding but less prone to wild swings. They are considered a steady, "safer" investment.

Balance is important here, because if you have too much exposure to stocks, you risk a huge loss during a market crash; too much in bonds, and you risk not having enough to retire.

Here's an example of how the rule is supposed to work: Say your stock holdings took an 8% hit. If you had all of your investments tied up in stocks, you'd lose 8%.

Because you invest in bonds — and your holdings increased 1.5% — that means your entire portfolio would be down by only 4.2%, cushioned by the bond earnings.

But while 60/40 has served investors well, some experts say it's in need of an update.

What you're likely to hear from your financial adviser is a call for a more complicated, more sophisticated mix of investments that still keeps to the fundamental principle of long-term growth.

You'll hear three big reasons for the call to change:

To be sure, investors who have employed the rule have succeeded.

Researchers at Duke University found an investor with a 60/40 allocation can expect an average annual return of 8.6%, based on data going back to 1926.

In the worst year, that allocation resulted in a drop in value of 26.6%, while in the best year it produced a gain of 36.7%.

Being 100% in stocks would have produced a gain of 9.9% but would have had much more volatility.

Investing only in bonds would have resulted in an average gain of 5.6% during that time.

But researchers noted those were only the averages and results can vary substantially depending on when investors enter and exit the market.

T. Rowe Price, for example, found that in the 10 years ending in 2009, the average annualized return of stocks was -3%, falling behind bond returns by 9%.

"Rules of thumb often lull people into a false sense of security," says certified financial planner Deana Arnett, a senior planning consultant at Rosenthal Wealth Management Group in Manassas, Va. "It may work; it may not. The problem is that they ignore individual factors."

Most financial professionals agree that investors need a mix of both stocks and bonds. It's just a matter of what that mix is.

For example, Mari Adam of Adam Financial Associates in Boca Raton, Fla., now calls the 60/40 rule a good "starting point" that should be adjusted based on each investor's situation.

Younger investors probably want to weight their portfolios much heavier toward stocks.

Because they have more time, they can take on more risk. Ideally, the investors shift further into bonds as they get closer to retirement.

One variation of the rule suggests investors should subtract their age from 110 or 120 to determine the proper amount of stocks they should be in.

By that measure, a 40-year-old should have a 70/30 to 80/20 mix.

Adam says investors also should consider the allocation of stocks within their stock holdings.

This means diversifying to create a mix of domestic, international, small cap, large cap, growth, value and dividend-paying stocks.

wad of cash in a nest

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But the rule — even in its modified form — is not universally embraced.

James Poe, founder of the Texas Retirement Specialists in Dallas, says the 60/40 rule was retired during the 2008 recession.

When Lehman Brothers failed that year, the price of bonds fell with the price of stocks, creating losses in both categories.

"At that point, if you were looking at account statements for your 60/40 portfolio, you were down across the board," says Poe. "The rule didn't work then."

He says a more important part of asset allocation today is make sure you have assets whose values aren't pegged to the stock market.

"You want to look for things that have no correlation to stocks. Real estate prices do not move in step with stock prices," Poe says.

Investors could buy property, but Poe prefers Real Estate Investment Trusts, or REITs, which allow investors to take an ownership stake in commercial properties. Some REITS are traded on the stock market, while others are private trusts that can be purchased only through an authorized broker or from the trust itself.

He says a balanced portfolio should hold a mix of stocks, bonds, REITs and even exotic investments like Master Limited Partnerships, which are publicly traded investments in energy production and distribution firms.

So, what should you do?

Your age and risk tolerance should help determine your investing path.

Just remember that following the 60/40 rule might not get you the maximum returns on your investments, but it's certainly better to diversify than to put all your money in either stocks or bonds.

The key is to buy for the long term in investments with sound track records.

"When you buy quality investments, you have the reassurance that even in bad times, that investment will see better days," says Arnett.