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Uncovering the 40/60 portfolio


40/60, 60/40 or 30/70. The term is among the most spoken about by financial advisers and other industry experts. At present, the focus of the discussion is on why the 40/60 portfolio is “broken,”  yet we rarely take a step back and think about it in its own right.

  • The term refers to the “construction” of an investment or retirement portfolio. In most cases, outside of the US, the first number refers to the allocation of a portfolio into low-risk assets, primarily bonds, and the second into growth assets, primarily shares. Ultimately, it speaks to asset allocation among available investments.

    This isn’t a new concept, but in my experience as a financial adviser, portfolio construction and asset allocation are not front of mind for most self-directed investors. In fact, they rarely garner a mention and are low on the priority list.

    Historically, the concept of a 40/60 portfolio is grounded in the concept of Modern Portfolio Theory and the idea of diversification. A 40/60 portfolio is said to offer the best of both worlds, being the ability to grow your capital through a significant allocation to shares, but also, with the ability to dampen volatility through a sizeable investment in high-quality bonds.

    Ultimately, the strategy is predicated on achieving the best possible return on your money, without taking more risk than is appropriate for someone in your circumstances. As is commonly the case, risk refers to the volatility in the value of your portfolio, not the permanent loss of capital.

    And this is where most people get lost. At its core, investment theory suggests that if you take more risk in growth assets, you should be rewarded with higher returns. But recent history has shown this isn’t always the case. In fact, those with larger allocations to bonds have tended to significantly outperform in a falling interest rate environment.

    This is the key issue that every investor, from endowment and pension funds to SMSF trustees, faces today. With bonds yielding as little as 1.6 per cent a year, they are almost guaranteed to deliver a negative return as interest rates eventually increase. Given this represents 40 per cent of the ‘portfolio,’ this is bound to hurt returns. In some cases, analysts are predicting that the long-term returns from a 40/60 portfolio may be as low as 2.2 per cent a year for the next decade.

    It is for this reason that many experts are pushing for a change in the 40/60 portfolio construction. At their core of this argument is the inclusion of a broader range of asset classes, including anything from credit, high-yield or junk bonds, private equity, infrastructure and hedge funds, in the pursuit of returns.

    But clearly this complicates matters even further. On the one hand, how does one gain access to, and assess, these without broad-based indices to compare? On the other, what is the appropriate allocation to each sub-asset-class?

    As always, I personally stress the need for a detailed Investment Policy document for every person managing capital, their own or others, to assist in guiding these decisions.

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