60/40 Portfolios Are a Scam (Here’s the Real Story)

Key Concepts

• Personalized Portfolio Construction: Rejecting the “one-size-fits-all” approach, emphasizing individual goals, time horizons, and realistic expectations.
• Savings vs. Investment: Reframing investment portfolios as savings plans focused on prudent allocation rather than speculation.
• Temporal Asset Allocation: Recognizing that asset allocation is fundamentally linked to finite time horizons and matching expenditures to future goals.
• Real Returns Focus: Prioritizing inflation-adjusted returns over nominal returns for accurate assessment of investment gains.
• Defined Duration: A novel portfolio construction methodology quantifying time horizons for investment instruments, mirroring fixed income principles, and managing sequence of returns risk.
• Asset Liability Matching (ALM): Aligning assets with specific financial liabilities and time horizons.

Portfolio Construction Principles & Historical Context

Cullen Roach, founder and CIO of Discipline Funds, advocates for a personalized approach to portfolio construction, detailed in his book Your Perfect Portfolio. He challenges the notion of a universally optimal allocation, arguing that a portfolio should be tailored to an individual’s specific needs and time horizon. Roach redefines “investment” as a form of savings, emphasizing the importance of focusing on real (inflation-adjusted) returns and realistic expectations. He highlights that the average investor doesn’t achieve headline stock market returns due to the impact of inflation, fees, and taxes.

The historical development of the 60/40 portfolio is traced back to the Wellington Fund and Walter Morgan’s post-Great Depression strategy, demonstrating its resilience across economic cycles. Roach stresses that diversification isn’t solely about asset classes, but also about diversifying across instruments with different time horizons. He quotes Brian Portnoi, stating, “Good diversification is learning to hate some part of your portfolio all the time.”

Innovative Portfolio Strategies

Roach introduces several portfolio strategies, including the Forward Cap Portfolio, which attempts to anticipate future market capitalization shifts based on five mega-trends: technology, human consumption, emerging markets, healthcare, and decentralization. Backtesting showed this portfolio outperformed the US stock market. He also mentions the conservative T-Bill and Chill Portfolio for short-term goals and the robust, all-weather Permanent Portfolio designed by Harry Brown.

However, the core innovation discussed is Defined Duration, a methodology designed to address the difficulty in communicating and managing time horizons, particularly within the stock market. This model, developed after the birth of his daughter and the COVID-19 market crash, aims to quantify a reasonable time horizon for judging investment instruments, mirroring the approach used in fixed income.

Defined Duration Methodology & Implementation

Defined Duration focuses on sequence of returns risk – the risk of experiencing poor returns early in retirement or during a critical financial need. It’s framed as a form of Asset Liability Matching (ALM), aligning assets with specific financial liabilities. The model estimates expected future returns based on potential maximum drawdowns in real terms.

Different asset classes exhibit varying defined durations: T-Bills have a duration of approximately zero, a 5-Year Treasury Note matches its modified duration (around 4.5 years), Technology Stocks currently have a relatively long duration (over 30 years), and Foreign Value Index has a shorter duration (around 15 years).

Discipline Funds offers three defined duration ETFs: DDV (5-year), DDX (10-year), and DDXX (20-year). These ETFs are characterized by low expense ratios and aim to generate stable returns over specific rolling periods. DDV, for example, includes a 15% allocation to shorter-duration equities to potentially enhance returns.

Market Inefficiencies & Behavioral Finance

Roach identifies a significant inefficiency in the investment landscape, noting a disparity between the assets held in expensive, tax-inefficient mutual funds (approximately $1 trillion charging over 0.5% in fees) and low-cost asset allocation ETFs (roughly $20 billion). He emphasizes the importance of compartmentalizing investments to mitigate behavioral biases, particularly regarding the stock market’s volatility. Defined duration allows investors to acknowledge short-term market fluctuations without disrupting their long-term financial plan. He views traditional Target Date Funds (TDFs) as “clunky” and believes defined duration offers a more customizable and flexible approach. He also notes that many portfolios are judged over inappropriately short time horizons, especially those with longer-term investment strategies, and that a 60/40 portfolio often behaves like a 10-12 year instrument.

Conclusion

The discussion underscores the need for a shift in perspective regarding portfolio construction, moving away from generic asset allocation rules and embracing a personalized, time-horizon-focused approach. The Defined Duration methodology offers a novel framework for managing sequence of returns risk and aligning investments with specific financial goals, potentially leading to more stable and predictable outcomes for investors. The emphasis on real returns, low fees, and behavioral awareness further reinforces the importance of a disciplined and informed approach to long-term financial planning.