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Investing fads come and go. But one style has endured since the 19th century: a classic "model portfolio" of 60% stocks and 40% bonds.
Since 1871, a 60/40 mix of U.S. stocks and bonds has returned an average 7.6% a year, according to Research Affiliates, a Newport Beach, Calif., investment company. Adjusted for inflation, the portfolio produced "real" returns around 5% — a respectable showing over more than 14 decades.
Yet while this timeless portfolio remains a staple of many financial plans, some experts say it may not be ideal in today's climate. From 2001 to 2010, returns averaged 3.8% a year, according to Research Affiliates. Over the next decade, annual returns are likely to average just 4.5%, says Christopher Brightman, head of investment management for the firm, or 2.4% adjusted for inflation.
Why such a dim 10-year outlook? Chalk it up to a persistently slow economy, low dividend yields and the potential for a bout of inflation that could wipe out real returns for both stocks and bonds.
The economy is growing around 2%, well below the 3.2% average from 1948 to 2012, according to tradingeconomics.com. Growth has been below 2% since 2000, on average, and few economists predict a return to 3% anytime soon. That doesn't bode well for corporate profits, which Brightman believes have peaked in this economic expansion.
Stocks may move higher as investor sentiment improves. But the main driver would have to be higher price/earnings ratios, which can only go so far without corporate profits catching up. Dividends are another key element of total returns, and they're currently low at around 2.1% for the S&P 500 (.SPX).
In the bond world, yields are being "repressed" by the Fed's loose money policy. Inflation may be tame today, Brightman says, but if it picks up and reaches 5%, bond prices will tumble and stocks will probably fall too, meaning the traditional 60/40 portfolio won't offer much return.
This may not come to pass, of course. The economy seems to be gaining momentum, the Dow (.DJI) has hit a string of record highs and Wall Street expects earnings per share for firms in the S&P 500 to grow 9.3% this year, according to Thomson Reuters I/B/E/S. Meanwhile, bond yields have stayed low, a sign that investors aren't overly concerned about inflation near-term.
Still, some market veterans argue that investors can fare better than the traditional 60/40 split. Adding some investments to protect against inflation can help avert "wealth destruction," says Brightman.
And there are ways to reduce the volatility of a 60/40 portfolio without compromising its potential gains, according to Alex Shahidi, a money manager with Merrill Lynch in Los Angeles, who recommends using investments that can produce higher "risk-adjusted" returns.
However you go, it's important not to increase your portfolio's risk above what you can handle. Adding some high-yield bonds and foreign debt can enhance your returns in normal market conditions, according to Jurrien Timmer, co-manager of Fidelity Global Strategies Fund (FDYSX), which tactically adjusts its investment mix. But they can be deadly when the markets tumble like they did in 2008.
"Diversification sounds great on paper," he says, "but it doesn't always work because markets are now so interlinked. You have to be very careful about where you may be taking additional risk."
Some funds take a tactical approach, holding a variety of assets to try and beat the 60/40 split.
Here are three model ETF portfolios to consider based on our research and discussions with professional money managers, strategists and analysts. As always, you should do your own research or consult an adviser before investing.
While the 60/40 portfolio is considered well-balanced, it's still sensitive to swings in the stock market. The correlation between a 60/40 portfolio and the S&P 500 is 98% — meaning they almost always move in the same direction, according to the Merrill Lynch money manager Shahidi. Though bonds help reduce the portfolio's volatility, the direction of the stock market drives much of the portfolio's returns, he says.
As an alternative, Shahidi suggests a portfolio of four asset classes: 20% stocks, 30% long-term Treasury bonds, 30% Treasury inflation-protected bonds (TIPS) and 20% commodities. (The ETFs above are based on his asset mix.)
Stocks and commodities do best when the economy is expanding, he says. When the economy is slowing or in recession, Treasurys and TIPS tend to do better.
The idea is that the portfolio is "largely indifferent" to whether stocks or bonds are rallying or inflation is rising or falling, making it a good all-season option, says Shahidi. It also should be less volatile than a traditional 60/40 split because it's more balanced.
Indeed, this portfolio has fared well, according to Shahidi's research. Based on market index returns, it gained 9.8% on average over the past 50 years, versus a 9% return for a 60/40 portfolio. (These and other return figures lower down are all unadjusted for inflation). Plus, the "economically balanced" portfolio has been one-third less volatile. The returns assume the portfolio is rebalanced every Jan. 1 back to its target allocation.
"If you keep it simple and own these four asset classes without getting too fancy, you can do better than most people," he says.
The downside: The portfolio is relatively defensive and may not keep up with a more stock-oriented portfolio in a rising market.
Investors seem to be falling in love with stocks again and not only because of the recent record high for the Dow. Volatility in the stock market has been exceptionally low. The VIX index — known as the "fear gauge" on Wall Street — has been falling during the past three years and is now 15 percentage points below its long-term average, according to Geoff Considine, a former NASA scientist who now develops portfolio management software in Boulder, Colo.
There are two possibilities moving forward, he says. Either the good times roll and volatility stays low, or it spikes back up closer to its average. Considine figures the latter scenario is more likely. The last time volatility fell to current levels was 2007, before the markets took a dive, he notes. Now, investors are flocking to stocks since bond yields are so low. That's suppressing stock market volatility as investors have grown complacent about the risks of investing in stocks. But eventually that too will end, he says.
Considine isn't predicting a crash tomorrow, and bond yields could remain depressed for some time — as they have in Japan for decades. But he says it may be prudent to build a "shock absorber" portfolio that can handle a spike in volatility without taking excessive risks.
One way to go? He suggests a mix of nine ETFs that include stocks, gold, commodities and TIPS. These assets should help insulate your portfolio from a "volatility shock," he says. And the portfolio returned an average 11.1% over the past three years, based on market index returns. Going forward, he anticipates a three-year annualized return of 8.9% based on "Monte Carlo" computer simulations, which attempt to predict returns based on economic scenarios and other variables.
The downside: The portfolio may lag if stocks continue to rally.
At today's prices, Research Affiliates' Brightman figures investors can do better than the 4.5% average annual return in a 60/40 portfolio. Investing in more attractively priced foreign stocks and bonds and some "inflation hedging" assets can boost returns by 1 to 2 points, he says.
Rebalancing once a year — selling assets that have risen and adding to the laggards — may add another 1%. And investing in equal-weighted or "fundamentally" balanced ETFs can enhance your returns over a market-cap weighted index, he says.
Overall, the mix he suggests is 20% high-grade U.S. bonds, 40% foreign stocks and 40% in "inflation hedges" such as TIPS, foreign bonds and commodities. (The ETFs above are based on his asset mix.) The risk should be similar to a 60/40 portfolio across various market environments, he says, and its foreign currency exposure should help protect against a weakening dollar and inflation, which he thinks are likely due to Fed policy.
Long term, Brightman estimates this portfolio should earn an average 7.5% annually. That assumes investors rebalance regularly, stay disciplined and stick with equal-weighted or fundamentally weighted funds.
The downside: The portfolio may be volatile and could post losses if there's a global sell-off in risky assets.
But stick with the plan long-term, Brightman says, and "you should do pretty well."
|ECONOMICALLY BALANCED PORTFOLIO||SHOCK-ABSORBER PORTFOLIO||REFLATION PORTFOLIO|
|iShares 20+ Year Treasury Bond ETF (TLT)||Vanguard Total Stock Market (VTI)||iShares Core MSCI EAFE ETF (IEFA)|
|PIMCO 15+ Year U.S. TIPS Index Exchange-Traded Fund (LTPZ)||Market Vectors Gold Miners (GDX)||PowerShares FTSE RAFI Emerging Markets Portfolio (PXH)|
|SPDR S&P 500 ETF (SPY)||PowerShares DB Commodity Index Tracking Fund (DBC)||iShares Core Total U.S. Bond Market ETF (AGG)|
|iPath Dow Jones-UBS Commodity Index Total Return ETN (DJP)||SPDR Gold Shares (GLD)||PowerShares DB Commodity Index Tracking Fund (DBC)|
|iShares TIPS Bond ETF (TIP)||Vanguard REIT ETF (VNQ)|
|Vanguard Extended Duration Treasury ETF (EDV)||iShares TIPS Bond ETF (TIP)|
|SPDR Barclays Mortgage Backed Bond ETF (MBG)||PowerShares Senior Loan Portfolio (BKLN)|
|iShares Core Total U.S. Bond Market ETF (AGG)||PIMCO 0-5 Year High Yield Corporate Bond Index (HYS)|
|SPDR Barclays Convertible Securities ETF (CWB)||Market Vectors Emerging Markets Local Currency Bond ETF (EMLC)|
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.
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