Elevate Your 60/40 Portfolio With These Simple Tweaks

Key Concepts

• Total Portfolio Approach: A portfolio construction method focusing on the behavior and risks of assets rather than simply asset allocation percentages (like 60/40). It categorizes investments into “Growth” and “Stability” sleeves.
• Growth Sleeve: Investments expected to perform well in strong economic environments, typically carrying higher risk.
• Stability Sleeve: Investments designed to provide protection during economic downturns, generally lower risk.
• Equity Beta: A measure of a stock's volatility in relation to the overall market.
• Duration: A measure of a bond's sensitivity to interest rate changes.
• Credit Spreads: The difference in yield between a corporate bond and a comparable government bond, indicating credit risk.
• Kalpers: California Public Employees' Retirement System, a large public pension fund.

The Evolution of Portfolio Construction: Beyond the 60/40

The traditional 60/40 portfolio – 60% stocks and 40% bonds – remains a viable investment strategy, but can benefit from refinement through the “total portfolio approach.” This approach, championed by Jason Keart of Morningstar, shifts the focus from what assets are held to how those assets behave and what risks they present. The core idea is to build a portfolio based on desired outcomes – growth and stability – rather than rigid asset class allocations.

Growth vs. Stability: Defining the Two Pillars

The total portfolio approach divides investments into two distinct categories: Growth and Stability. The 60/40 portfolio implicitly aims for this balance, with stocks providing growth and bonds offering stability. However, the total portfolio approach encourages a more nuanced understanding of risk within each category.

• Growth: This sleeve aims to generate returns during favorable economic conditions. It includes assets whose risks are tied to the economic cycle, such as stocks, high-yield bonds, private credit, and even cryptocurrencies.
• Stability: This sleeve focuses on protecting capital during economic downturns. Traditional bonds are a core component, but the approach also considers lower-risk equities like dividend growth stocks and low-volatility factor ETFs.

Rethinking Traditional Asset Classes

The total portfolio approach challenges conventional wisdom regarding asset classification. For example, high-yield bonds, often included in the 40% bond allocation of a 60/40 portfolio, are re-evaluated. Keart argues that high-yield bonds carry significant economic risk, as their yields are higher because of the increased risk of default during economic slowdowns. He suggests allocating a portion of high-yield bonds to the Growth sleeve, acknowledging their cyclical nature.

“The worst thing that could happen to someone is when there is some kind of draw down in their portfolio, if it's more severe than they thought it was going to be, that's when I think people make mistakes and sell too early.” – Jason Keart.

Similarly, certain stocks can contribute to the Stability sleeve. Dividend growth stocks and low-volatility ETFs, while still equities, tend to be more stable than high-growth or small-cap stocks and can therefore partially fulfill the role of providing portfolio stability.

A Hypothetical Portfolio in Action

A hypothetical portfolio constructed using the total portfolio approach might allocate 60% to Growth (US stocks paired with high-yield bonds) and 40% to Stability (US core bonds with cash). In an upswing, this portfolio might slightly underperform a traditional 60/40 due to the inclusion of potentially lower-returning assets in the Growth sleeve. However, it’s designed to experience less severe drawdowns during market downturns, enhancing investor resilience.

Challenges and Considerations

Implementing the total portfolio approach isn’t without its challenges. Keart acknowledges the potential for overcomplication, as the approach allows for extensive analysis of asset characteristics and risk factors. He cautions against relying solely on past performance, as market dynamics can shift.

“You could really make it as complicated as you want because you could really measure the past um performance or risk of anything in a million different ways.” – Jason Keart.

Furthermore, accurately assessing the risk and behavior of assets requires ongoing monitoring and adaptation.

Adoption and Momentum

The total portfolio approach is gaining traction, notably with the recent decision by the California Public Employees' Retirement System (CalPERS) to adopt the strategy. While not entirely new – firms like American Funds have long employed similar outcome-oriented approaches – CalPERS’ move is expected to draw significant attention and potentially accelerate adoption by other institutional investors. Risk parity strategies and alternative asset managers have also historically utilized similar bucketing approaches.

Practical Application for Individual Investors

Individual investors can implement the principles of the total portfolio approach by becoming more mindful of the role each investment plays within their portfolio. Instead of blindly following a 60/40 rule, investors should consider the risk profile of each asset and allocate accordingly. This includes recognizing that assets like private credit, high-yield bonds, and cryptocurrencies are not “safe havens” and carry significant downside risk.

“I think the 60/40 is not broken, but that doesn't mean it can't always get a little polish. And I think applying some of the um concepts of the total portfolio approach to your own portfolio uh can definitely make your portfolio a little bit more resilient and hopefully help you stay invested over the long term.” – Jason Keart.

Conclusion

The total portfolio approach offers a sophisticated refinement of the classic 60/40 portfolio. By focusing on asset behavior and risk, rather than simply asset allocation percentages, it aims to create more resilient portfolios that can withstand market volatility and help investors stay disciplined over the long term. While it requires a more nuanced understanding of investment characteristics, the core principles can be applied by individual investors to build smarter, more effective portfolios.