Vanguard challenges the traditional 60/40 investing rule by proposing a flipped allocation: the 40/60 portfolio. This new approach allocates 40% to stocks and 60% to bonds, aiming to balance returns and risk more effectively in the current market environment.
The classic 60/40 portfolio, with 60% stocks and 40% bonds, has long been favored for combining growth with moderate volatility. Stocks drive growth but come with higher risk, while bonds typically offer lower returns and reduced volatility. The strategy is often recommended for investors nearing retirement or with a medium-term horizon of 5 to 10 years.
However, stocks have experienced an extraordinary run. The S&P 500 increased by 216% in the past decade, averaging about 12% per year, according to The Motley Fool. Conversely, bonds underperformed; for example, the Vanguard Total Bond Market Index Fund posted a five-year average return of -0.5%. This divergence raises concerns about traditional portfolio allocations.
Vanguard’s global head of portfolio construction, Roger Aliaga-Díaz, explains the rationale behind increasing bond exposure. He notes that U.S. stocks currently appear overvalued, with the cyclically adjusted price-to-earnings (CAPE) ratio for the S&P 500 at 40.40. This level rivals the peak during the dot-com bubble, signaling potential downside risk.
Market analysts warn that such elevated valuations seldom sustain long-term outperformance. Forecasters expect a challenging decade ahead for stocks, with Vanguard projecting modest annual returns of 3.5% to 5.5% for U.S. equities overall. Growth stocks, including major tech companies known as the Magnificent Seven, might return only 2.3% to 4.3% annually.
In contrast, bonds are expected to offer more attractive yields. Vanguard forecasts U.S. bond returns between 3.8% and 4.8%, with foreign bonds possibly delivering even higher gains. Because of this, modeling a portfolio with 60% bonds could achieve similar returns to the traditional 60/40 mix but with less volatility.
The 40/60 portfolio roughly comprises 36% U.S. bonds, 24% international bonds, 15% U.S. value stocks, 14% international stocks, 6% U.S. growth stocks, and 5% U.S. small-cap stocks. Vanguard emphasizes stocks expected to perform well amid current market conditions: value stocks, which trade at lower prices relative to earnings; small-cap stocks, less influenced by tech-driven exuberance; and non-U.S. stocks, predicted to outperform domestic peers.
Vanguard expects value stocks to return 5.8% to 7.8% annually, small-cap stocks to rise 5.1% to 7.1%, and international stocks to generate 4.9% to 6.9% per year over the next decade. This stock selection strategy reflects concern over the overvaluation of the biggest growth stocks.
Despite these projections, many investors remain hesitant to increase bond holdings after years of weak bond performance compared to stocks. Some prefer minimizing bonds or avoiding them entirely to maximize portfolio growth potential. Caleb Silver, editor in chief of Investopedia, highlights that growth in portfolios typically comes from stocks despite short-term fluctuations.
Vanguard’s flipped allocation is presented more as a conceptual framework than a strict rule. Investors with more aggressive allocations might adjust less dramatically, for example shifting an 80/20 stock-to-bond ratio to 70/30 instead of 40/60. The goal remains managing risk while maintaining competitive returns in a market phase where stock valuations are stretched and bond yields are relatively attractive.
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