A recent MarketWatch article by Brett Arends caught my attention. The premise of the article was that a balanced portfolio consisting of 60 percent stocks and 40 percent bonds was the equivalent of handing "your grandmother's retirement savings over to a cardsharp in the hope that he might gamble with them on a riverboat casino." Pretty scary stuff.
Arends asserts that the typical balanced portfolio, which mixes stocks and low-risk bonds, is fatally flawed. He writes (without any support) that both stocks and bonds are "almost certainly overvalued," leading to the conclusion that investors in these portfolios are "taking a huge risk." He notes that investors in balanced portfolios starting in 1966, who rebalanced once a year, lost almost two-thirds of their purchasing power over the next 15 years. Even more troubling, if these hypothetical investors withdrew 5 percent of their portfolios in the first year, and increased withdrawals each year to keep pace with inflation, within 18 years the portfolios were wiped out, decimated by poor returns from stocks and bonds.
If these observations have merit, the ramifications are broad. The entire premise of target-date funds is based on using a balanced portfolio that becomes more conservative as investors age. Many advisers (myself included) recommend balanced portfolios to our clients.
Is Arends correct?
The initial problem with assessing the merit of Arends's conclusions is the fact that he does not indicate what is in the 60/40 portfolio he is bashing. Did he use an actively managed portfolio of high-expense-ratio stock and bond funds or low management fee index funds? Did he use mutual funds or individual stocks and bonds? What were the maturities of the bonds in his portfolio? Without this information, it is impossible to evaluate his observations.
Perhaps these material omissions are why I am unable to verify his calculations. I ran the data for the 15-year period commencing in 1966 used by Arends, using the S&P 500 Index for the stock portion of the portfolio and the five-year Treasury bond for the bond portion. The annualized return was 6.61 percent, versus inflation of 6.87 percent. The growth of $1, with annual rebalancing, was $1.65 versus $1.71 when you take inflation into account, for a loss of purchasing power of less than 4 percent (and not the "almost" two-thirds loss referenced by Arends).
According to respected journalist and author James Stewart, a "simple mix of 60 percent stocks and 40 percent bonds" outperformed large, medium and small endowments over one-, three- and five-year periods. Over 91 percent of smaller endowments (with assets of less than $1 billion) underperformed this balanced portfolio in every time period measured.
Arends is correct that withdrawing at the rate of 5 percent a year, and adjusting withdrawals to keep pace with inflation, presents a risk of outliving your money. No one is suggesting that a 60/40 balanced portfolio guarantees you won't deplete your assets (especially at those withdrawal rates). But the long-term data indicates focusing on your asset allocation and keeping your costs low maximizes the likelihood of a successful retirement plan.
Vanguard recommends withdrawals of 4 percent of your account balance in the first year, with subsequent withdrawals adjusted for inflation. Vanguard notes that, while nothing is guaranteed, "Studies suggest that such a disciplined withdrawal strategy has a good chance of stretching your savings over 30 years." Given the current low interest rate environment, a maximum withdrawal rate closer to 3 percent (or perhaps even a little less) may be more realistic.
Investors who are concerned about inflation should limit their bond holdings to short and intermediate-term bonds and avoid bonds with long maturities. Inflation-wary investors should also consider adding commodities and TIPS to their portfolios.
Arends provides no recommendations for a portfolio more likely to provide investors with higher expected returns at an acceptable level of risk. A balanced portfolio is not perfect, but it is likely far better than using the services of a broker or adviser who touts his expertise in "beating the market" by stock picking, market timing or fund manager selection.
Dan Solin is the director of investor advocacy for the BAM Alliance and a wealth adviser with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His latest book, 7 Steps to Save Your Financial Life Now, was published on Dec. 31, 2012.
The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information, and content on this blog is for information purposes only and should not be construed as an offer of advisory services.