Time To Ditch The 60/40 Rule

Summary

• Both, stocks and bonds, are down significantly in 2022.
• Inflation remains at a 40-year high and interest rates continue to rise.
• I present my alternative approach to mitigate risks, earn high yield, and position your portfolio for upside.
• Looking for a portfolio of ideas like this one? Members of High Yield Landlord get exclusive access to our model portfolio. Learn More »

William_Potter

Historically, one of the most popular allocation strategies has been to allocate 60% in stocks and the remaining 40% in bonds. There are some variations of this strategy but the idea is simple:

The stock component should provide high total returns during bull markets, while the bond component should provide income and stability during bear markets.

When stocks dip, bonds typically remain stable, and therefore, this strategy also allow you to opportunistically buy the dips as you rebalance capital from bonds to stocks during bear markets.

This should lead to superior risk-adjusted returns over time and several studies have proven the benefits of this approach.

Below, you can see that the 60/40 portfolio has not only been safer, it has also been more rewarding than a portfolio that's fully invested in stocks (SPY):

Shroders

But before you blindly structure your portfolio after this model, you need to consider that today's environment could be particularly dangerous to this allocation strategy.

In fact, since the beginning of the year, the 60/40 portfolio has lost % in value, which is one of the worst drops for this strategy:

Data by YCharts

Could the losses get even worse?

We don't know, but even if the market bounces back, we think that the 60/40 portfolio strategy is now outdated and some adjustments are needed for today's evolving world.

Below, we discuss the biggest issues of the 60/40 portfolio, and finally, we explain how we are structuring our portfolio to mitigate risks and optimize future upside potential.

Increased Correlation Between Stocks and Bonds

The basic idea of the 60/40 portfolio is today broken.

Stocks and bonds have become increasingly correlated and therefore, bonds don't provide the stability that they used to.

You can clearly see this in the performance of both asset classes in 2022:

Data by YCharts

Why is this?

Historically, when we have hit a recession and stocks have plunged, bonds have remained fairly stable and in some cases even gained value because recessions have also led to lower inflation and declining interest rates. All else held equal, this should increase the value of bonds, especially as increasingly many investors turn to bonds for safety and bid up their prices.

But today is different

Inflation is currently at a 40-year high, hitting 8.3% in August, and the Fed needs to urgently bring it back under control.

Unfortunately, this high inflation is happening even as the economy is rapidly dipping into a recession, which would typically warrant rate cuts, but this isn't an option today.

Therefore, the Fed is forced to aggressively hike rates even as we head into a recession, and this is well-reflected in the steeply inverted yield curve:

Federal Reserve

Even after many sizable rate hikes, today the Fed funds rate is still just 3.25% because we started from only 0.25% earlier this year. 3.25% may seem high compared to where it was earlier this year, but it is still very low compared to past funds rate history and our current inflation.

Therefore, many more rate hikes are expected in the near term, and the Fed made this clear at the latest meeting.

This puts both, bonds and stocks, in a tough position.

On one hand, bonds are suffering from high inflation and rising interest rates.

On the other hand, stocks are suffering from the recession and rising interest rates. Many businesses are also very negatively impacted by cost inflation, the inability to pass price hikes to customers in a recession, and the strong USD caused by rate hikes.

So, both are now suffering, correlation is rising, and the past diversification benefits enjoyed by the 60/40 portfolio are disappearing. The only way out of this would be if inflation suddenly drops back down to normal levels and the Fed begins to cut interest rates, but how likely is that?

It is tough to say, but at least in the intermediate term, it appears unlikely, and therefore, you cannot simply rely on stocks and bonds in today's world anymore.

Enter The World of Alternative Investments

Stocks and bonds are by far the most popular investments, and this is largely because they are easy to access. You enjoy liquidity, low transaction cost, and professional management, and you can easily build a diversified portfolio. There are also plenty of analysts providing research on stocks and bonds so you can efficiently access information on the latest opportunities.

But, in a weird way, this is potentially also the demise of stocks and bonds. These asset classes have become so crowded and competitive that it is now more difficult to find opportunities and most stocks/bonds have become closely correlated. The rise in popularity of passive ETFs and index funds have made it such that everything goes up or everything goes down, and diversification benefits are not as great as they used to be.

My solution is to invest heavily in alternative asset classes such as:

Farmland:

Farmland Partners

Apartment communities:

Armada Hoffler Properties

Private equity:

Global PMI Partners

Industrial warehouses:

EastGroup Properties

Private property loans:

EstateGuru

Overall, my exposure to alternative investments is today about 60% and the rest is mainly invested in traditional stocks. I hold very few bonds because I have a long-time horizon, high-risk tolerance, and I fear that bonds are set for more pain due to the high inflation and rising rates.

Why invest so heavily in alternatives?

There are many reasons, but here are the four most important ones:

• Reason #1: Diversification: You actually get to mitigate risks via diversification. As an example, the fundamentals of farmland are completely different from those of regular stocks or even bonds. Farmland REITs (FPI; LAND) benefit from the inflation as higher crop prices lead to higher property values and rents. You get real diversification benefits because the fundamentals are uncorrelated with the broader economy.

• Reason #2: Inflation-protection: Most, but not all, alternative asset classes offer better inflation protection, particularly those that are backed by real assets. Farmland, apartment communities, warehouses, etc., are all excellent examples. The high inflation leads to higher rents and higher replacement cost. Unlike many businesses, REITs and other landlord are able to pass rent hikes to their tenants because the real estate they occupy is growing is value and essential to them.

• Reason #3: Income: Today, a lot of alternative asset classes are heavily discounted, and as a result, they also offer high yields, particularly in the REIT market. To give you a few examples, EPR Properties (EPR) yields 9%, NewLake (OTCQX:NLCP) yields 11%, and W.P. Carey (WPC) yields nearly 6%. The high yield is great in today's uncertain environment because it provides a steady return that's independent of the market itself.

• Reason #4: Mis-pricings: The recent market crash has brought down a lot of listed alternative investments, including REITs (VNQ), BDCs (BIZD), and others. Many now trade at steep discounts relative to the underlying value of their assets, which essentially means that you get to invest in these alternative assets at a discount, and get the added benefits of liquidity, diversification, and professional management for free on top of it. To give you an example: Prologis (PLD), the leading e-commerce-focused industrial REIT, is today priced at an estimated 25% discount relative to the underlying value of its real estate, and the value of this real estate continues to grow. The rents on its new leases are up 20%+ in 2022, and the strong growth is expected to continue as more and more companies invest in e-commerce and bring larger portions of their supply chains back to the U.S.

So in short, I think that alternative assets, and to be more specific, listed real asset companies and private equity firms, have a lot to offer in today's environment.

They often trade at large discounts to fair value, offer real diversification benefits, and high income while we wait for the recovery. Of course, they are not immune to volatility either. Most REITs are down significantly in 2022. But their fundamentals have remained strong as they benefit from inflation and aren't heavily impacted by rates since they use little debt, and most of it is fixed rate and has long maturities.

This is why I prefer to invest heavily in these alternative investments instead of following the 60/40 portfolio strategy.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of EPR; NLCP; WPC; FPI either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[Workinhard]

Those aren't alternative investments , they are stocks in different asset classes and have had poor performance similar to everything else. Based on where we are today, now is probably a good time to invest in a 60/40 portfolio, as it's more likely to return to is mean return history rather than continue to under-perform.

[Jussi Askola, CFA]

@Workinhard Yes, they are alternative investments. The returns of REITs are near-perfectly co-integrated (measure of long term correlation) with those of private real estate, which shouldn't come as a surprise since they own nothing else than real estate. Same for those other publicly listed alternative investments

[dougkitchen]

60/40 is good if your short 60%stocks/40%bonds. The trick is always when to cover and go long. Fed policy might give us a clue.

[RWilliam]

I disagree. IMO the time to ditch 60/40 was a year ago or so. Now’s the time to start putting cash from stocks into bonds.

[Jussi Askola, CFA]

@RWilliam Of course. I think it was time to ditch it a long time ago. But now it is becoming particularly dangerous. Btw, bonds still give you a negative return after taxes and inflation.

Feel free to join us for a 2-week free trial to access all our Top Picks: seekingalpha.com/...

[Maxlzzp]

Here we go again. LAND YTD (-46%). MAIN YTD (-25%). Just examples.
My 60/30/10 Portfolio is down (-11%), has a 4.7% Yield at .33 expense ratio.
10% REITS/ 10% Alternative: BX, ARCC,DBMF. Cash is King as I am able to buy stocks at a discount. As a retiree you want Low Vol, Steady growth and Yield. Retirees are now most likely taking distributions.

[Jussi Askola, CFA]

@Maxlzzp You are referring to a few individual companies. Cash costs you a lot in the long run in missed performance. You cannot time the market. Only hold enough to sleep well at night.

[Maxlzzp]

@Jussi Askola As a Retiree Not Timing Market. And I am not 100% Cash.
I use that cash as rebalancing when there is Market displacement and eventually taking distributions when the Market is down like 2022.

[SilverBandit]

@Jussi Askola I think it's possible to time the market in certain instances. For example, I should of known that a stock like SE was capable of falling a lot further than I originally had thought. It would have saved me a bunch of money selling a bunch of my shares at 250 instead of 100ish. A lot of other high growth, low/zero profits stocks are the same.

[Income4ever aka Cyclenut]

Regarding the 60%-40% strategy you nailed it 100%.
Hi quality reits, pipelines, BDCs and tobacco stock are my staples in my 85% stocks / 15% bond retirement portfolio and its been delivering consistent, rising income for years ...

[Jussi Askola, CFA]

@Income4ever aka Cyclenut Thanks for sharing!

[glinsight]

I agree that alternatives are a good add to most portfolios. It used to be relatively difficult for a retail investor to get into alternatives, but now it’s easier and much less expensive. The ‘traditional wisdom’ of a decade ago was to have 5% - 10% REITs as a part of the 60% stocks. Today, that could well be a larger number, and displacing a part of the bond allocation.

However, bonds quit providing the stability they used to because bond yields have been exceptionally low. This is changing. I already see articles suggesting that it’s again time to be adding bonds. I suspect that the 60/40 portfolio, after having a couple bad years, and one disastrous year, will be back in favor before long. Of course, no one will call it a 60/40 portfolio.

[Jussi Askola, CFA]

@glinsight Thanks for sharing your thoughts. I agree. Feel free to join us for a 2-week free trial to access all our Top Picks: seekingalpha.com/...

[Dividend Miner]

I like the advice to diversify. REITs make sense in this regard. When I look at EPR, I have concerns that it may not come back with regard to the entertainment sector. If one invested $10,000 in EPR ten years ago, it would now be worth $14,066, which is not as good as the SPY (which grew to $29,895 over the same period of time). The dividend income from EPR from that investment ten years ago would be $1294 per year today. LAND given the same scenario of investing $10,000 ten years ago gives $18,000 and a yearly income of $561. I think we can do better with other REITs or other investments.

[Jussi Askola, CFA]

@Minemount EPR is a triple net landlord. Remember that as it makes a huge difference. It earns steady and pre-agreed rents from experiential businesses. It does not operate the businesses

[Income4ever aka Cyclenut]

@Jussi Askola
I got back into EPR at $36 partly based on you and P Drakes high confidence in EPR... another highly respected SA RE author strongly disagree with investing in EPR so time will tell

[Jussi Askola, CFA]

@Income4ever aka Cyclenut Thanks for sharing

[generalist27]

@Jussi Askola curious, if you by any chance have a strong opinion or any writings on the sustainability and growth prospects of the NLCP dividend? From my vantage point the main risk is that their tenants go out of business one by one. OTC is not ideal but also probably increases the yield and in the unlikely event of up-listing that would obviously boost the stock price a lot. I'm more interested in your opinion on the dividend safety and growth (relative to the very high yield).

[Maxfishh]

@generalist27 industrial RE broker in AZ here. The fact that they’re focused on limited license states is huge. The licenses are tied to the real estate and the licenses in limited license states keep going up from limited supply big demand. IMO the key to a successful cannabis REIT is focusing only on limited license states. Listening to Len Tannenbaum podcasts shed more light on the strategy

[Jussi Askola, CFA]

@generalist27 We are bullish on NLCP. The dividend growth will slow down, but we expect it to keep growing, which is quite exceptional for a REIT that's priced at such a high yield. We own it at High Yield Landlord

[Catskills1]

@Jussi Askola Thanks for the article. Having followed your analysis now for several years, and just looking back along this year's downturn, I see the following. First, as inflation took off, REITs, one of your main alternatives, showed better results for those that benefitted more in inflationary times (like apartments) and with better price escalators (like VICI), than those that benefitted less (like net lease with long term agreements and small rent increases). Second, as the Fed pushed up interest rates, all REITs have fallen in value, so much so that REIT results seem to have tracked like the bond and stock results you highlight above. Your strongest argument above is diversification, however, real assets have not helped investors escape the current downturn in their portfolios. A positive point of the REIT world in the current environment, which you have not touched on, is that REITs, while tracking downward in share price like stocks and bonds, pay much better dividends, which is a gain investors can enjoy while they wait for a turnaround. This might make REITs a better net investment for those with current cash to deploy.

[Jussi Askola, CFA]

@Catskills1 Thanks for sharing your thoughts. Simply based on the share price, there has been much diversification so far this year, but prices are always highly unpredictable and this could change. Based on fundamentals, there have been significant diversification benefits and that's what matters to me since I focus on the long run.

[Catskills1]

@Jussi Askola Agreed. Based on the history of the GFC and the pandemic lows, there are great REIT values out there. Identifying the better fundamentals and averaging in is the best one can do. Guessing bottoms is impossible, but averaging in at these levels should pay off nicely to those who can wait.

[DougBodde]

Jussi and Austin: you guys have separate views of things, producing conflicting output between the two of you. Very respectfully, it’s time for a professional unwind.

[Jussi Askola, CFA]

@DougBodde What do you mean? We may occasionally disagree on a specific company, but it is rare and when it occurs, we don't try to hide it. I try to encourage disagreements and debates. It can only help to provide different perspectives.

[DougBodde]

@Jussi Askola he’s a deflationist (Cathie Woods is Right) and you are quite concerned about rising rates and inflationary pressures. These make for very different investment choices, regardless about how you feel about any individual company.

[Jussi Askola, CFA]

@DougBodde I also believe in lower rates for longer.

[sbielaws]

I looked at investing in Farmland but most of the offerings were in CA. My concern is CA cutting their water.

[Jussi Askola, CFA]

@sbielaws They spend a lot of time working on that specific topic. Their properties have good access to water.

[Mikelski]

@Jussi Askola which of the two farmland reits you mentioned do you personally prefer?

[Gladiator321]

Hey Jussi, PLD looks interesting and so does REXR, don´t you think?

[Jussi Askola, CFA]

@Gladiator321 I agree. There are many great opportunities among industrial REITs. But my top pick is another company. Feel free to join us for a 2-week free trial to access all our Top Picks: seekingalpha.com/...

[Money&Money,LLC]

How safe are the dividends of these beaten down REITS?

[Jussi Askola, CFA]

@Money&Money,LLC Most of them are safe. REITs have even hiked dividends in 2022, despite the sharp sell off. Balance sheets are the strongest ever in the sector.

[User 56360468]

What the 40 is determines whether 60/40 can still work

Well selected and well diversified portfolios of junk bonds maturing in the next 2 to 5 years will avoid market risks while allowing interest payments comparable with dividend paying stocks. The bond rating agencies usually can predict insolvency better than stock analysts can predict declines in markets and stock prices

[Jussi Askola, CFA]

@Found.Alpha Junk bond investing is not for the average individual investor in my opinion. It is a game that requires a very different set of skills than regular equity investing.

[User 56360468]

@Jussi Askola junk-bond investing is out of the mainstream because it does not generate the frequent buys and sells that investment companies get their revenues from. Therefore they do not market junk-bond investing and the financial news channels mostly cater to their advertisers. Their primary advertisers buying commercial ad time are investment firms seeking to buy or sell stocks for retail investors taking advice from a former investment somebody turned pundit yelling "BOO-YAHH" on the tv.

The truth of investing is the average person lacking at least some basic college level classes in investing and portfolio management has no business whatsoever investing their own money, if they will actually need any of that money in 5, 10 or 20 years. I must wince at the bad ideas of many on this forum who are putting a disproportionate amount of money into high PE tech stocks, etc. They obviously suffer from normalcy bias or else do not remember what happened between 2000 and 2012, or similar declines in the past

junk-bond investing is relatively easy because they have ratings assigned to each bond. so long as you diversify properly, and buy bonds with near term maturities, and do some basic due diligence with regards to the company's earnings and revenue risks, it’s a lot harder to lose principal than it is with stocks

[Jussi Askola, CFA]

@Found.Alpha Thanks for sharing your thoughts

[High Yield FIREVestor]

REITs hedge against inflation? Someone would have to explain this to me.

With this crazy bear market, no sector is untouchable. YTD

VOO, -24%
VNQ, -29%

How have REITs been inflation hedge? No REIT has been spared. But I appreciate the article.

[Jussi Askola, CFA]

@FirstFIREWealth REITs have historically generated high total returns during times of high inflation on average. This does not mean that they are immune to volatility or that they will move 1-to-1 with inflation. Over time, their value grows faster than the rate of inflation and there is co-integration around the same factors.

[Lake OZ boater]

@FirstFIREWealth For your due diligence on REITs...

1. "Investor takeaways: The fact that, from January 1978 through July 2022, the monthly correlation of the Dow Jones U.S. Select REIT Index with five-year Treasuries was just 0.07 indicates that there has been very little correlation between the level of interest rates on REIT returns. Thus, it should be no surprise that changes in interest rates have had an ambiguous relationship with REIT valuations and returns. As Anderson, Beracha and Propper demonstrated, the absolute starting level of rates matters, the strength of economic conditions matters (rising rates signal a stronger economy), and credit spreads matter as well. "

See: "HOW DO INTEREST RATES IMPACT ON REIT RETURNS?"

www.evidenceinvestor.com/...

2. Rob Arnott is Chairman of the Board and Founder of Research Affiliates, and he was a guest on this weekend's PBS show for investors called WealthTrack (link). It was an interesting interview if looking for some ideas about skating to where the puck might go.

If you are pressed for time, here's an exec summary. Arnott co-manages the PIMCO All Asset Fund, which is 20 years old this year. For the current environment, he is recommending a diversified basket of inflation hedges which are held by his fund. Those include...

-Emerging Market stocks & bonds
-REITs: Real Estate Investment Trusts
-Commodities

(26:26) wealthtrack.com/...

3. See also: "Seeking Diversification? Forget REITs and Consider Utilities"

Symbol---------------------------------2022 Total Returns
VNQ-------------------------------------(-28.8%)
XLU--------------------------------------(-5.6%)
RYU-------------------------------------(-4.2%)
VPU------------------------------------- (-6.2%)

Source: www.dividendchannel.com/...

Article: www.morningstar.com/...

Diversification remains the only "free lunch" in investing. Hope this is helpful for your research.

[High Yield FIREVestor]

@LakeOZ boater what's your point? Are you agreeing with me that REITs are far from being inflation hedge?

[malaparte]

Need to correct- On the other hand, socks are suffering from the recession and rising interest rates.
Another question. Could it be that various billionaires who bought REITS a few months ago, were buying at the top.

[Jussi Askola, CFA]

@malaparte Thanks! Requested an edit.

Blackstone has bought $30 billion of REITs in 2022 and continue to buy more today.