The 60/40 Model is Dead. Very Dead. – The NEST Edge

The NEST Edge

The NEST Edge is a monthly webinar hosted by NEST Financial Founder, Dan Dillard, with CIO and Partner, Sean McDougle. They discuss what the markets and economy are currently doing and add their outlook on portfolio management. You’ve seen us talk about “Sean’s process” and how we do things different than other firms – well, The NEST Edge shows you exactly what we mean by all that! ICYMI, you can watch this month’s NEST Edge on our YouTube channel.

July 2021

RIP to the 60/40 model – this month, Dan and Sean are delivering an honest eulogy and their most sincere condolences to this “Lazy Portfolio.” Starting off with a quick history lesson on Modern Portfolio Theory and how the 60/40 model rose in popularity, Dan and Sean get into why the model is outdated and inefficient in today’s modern market. They share some insight into why certain advisors choose to use it anyway, and get into which sectors of the market today – specifically bonds and treasuries – are making this irresponsible strategy verge on dangerous. Finally, they share the details of Sean’s process and how NEST models do it differently – and achieve annual return rates to match. 

Highlights include:

• An explanation of Modern Portfolio Theory and the strategy behind the 60/40 model
• Why this is outdated and incomplete, having been developed before the Internet and ignoring the global economy and 50% of the market
• What makes this portfolio “lazy” and how some advisors choose to utilize it for their own personal benefit
• How bonds and treasuries are killing this model
• NEST portfolio performance over 2020 as an example of why and how actively managed portfolios are superior
• What we mean by active portfolio management
• An introduction to NEST’s five models and their annual rate of return goal

A Letter from Sean

For literally decades, the standard structure of a stable portfolio has been the ol’ 60/40. That’s 60% equities and 40% bonds. And sure, there’s some surface-level rationale justifying this formula. You have 60% of your money working to grow while 40% functions as a stable foundation to get you through the tough times. And… that’s where the justification ends.

I could write a book on why this structure sucks, but I’ll start with the most obvious reason – it ignores two major markets: currencies and commodities. You might remember one of these markets from May’s NEST Edge (http://nestfinancial.net/sell-in-may-if-youre-a-dummy-the-nest-edge/) , but in case you missed it, I’ll sum it up for you – if a portfolio manager ignores these markets, they’re a dummy. I’m not saying they’re idiots themselves, but more so that either a mentor failed them in their training or they haven’t had enough experience yet.

The markets tend to do wild things, and there is no getting around that. But, if you’re paying attention to all four major markets (equities, bonds, currencies, AND commodities), you will be way less surprised than the talking clowns on CNBC. But of course, it’s easier (about 50% less work) for portfolio managers to look at only two markets, instead of four.

Which brings me back to my hypothetical book. I think the title of my book about why the 60/40 model is six-feet-under would be called The Lazy Portfolio. In fact, from this point on, instead of calling it the 60/40 model, I’m going to call it by its true name: the lazy portfolio. Why do I call it that? Great question. Because, it’s lazy. It relies on archaic theories that no longer apply to equities or bonds, instead of taking the uphill path-less-traveled and utilizing data to understand modern markets.

In the good ol’ days, you would buy US Treasuries for the dividends and a guaranteed return of your capital. Currently, buying a US Treasury will give you 1.5% interest annually, which is lagging inflation by about 3.5%. So, as of today, buying a US Treasury costs you 3.5% a year in purchasing power. Which isn’t very smart, and one could say (well actually I did) it is a dumb, dumb idea. In addition, the situation isn’t getting any better anytime soon when it comes to bond rates.

In short – we had a debt problem before COVID and Corporate America got through it by adding more debt. I’ll admit there is a really low probability this melts down because the Treasury and the FED have proven again and again they will step in; it is this stepping in that has and will keep bond rates low for a very long duration.

Now you can start seeing what I’m getting at: instead of having 40% of your money working as a foundation, in today’s economy allocating 40% to bonds ends up losing you money and ultimately dragging the portfolio’s performance. Alright Sean, thanks for the bonds tutorial, but I thought we were talking about the Lazy Portfolio.You’re right – let’s get to the part where the rubber meets the road: the returns.

As an example, let’s say that you have an annual goal of 8% portfolio growth and you get a yield of 2% from your bonds portion (a generous hypothetical). That 60% portion of the pie in equities has to do 12% annually to offset the bonds. On the equities side, things go totally and completely crazy. Maintaining 60% equities, no matter what sector, style, type, or country, at all times, and expecting to hit your return goals consistently is insanity. The theories that it’s based upon are so intertwined with academia and what “should” happen, rather than how the markets actually behave today.

In my opinion, those that hide behind academia (past and present) should have to get in the game with real bullets firing for some period of time before releasing studies and theories. This “60% equities strategy” has the final fatal flaw of not understanding or even trying to pretend to care about where we are in the business cycle. These strategies hide in the average of things, when it’s so important to pay attention to the particular details.

There are times in the business cycle when you should have 80% equities, and there are times when you should have 20%. There are times when you should have more foreign exposure, and times when you should stick with domestic exposure. Yes, I’ll obviously agree that the equity markets do go up in the long run, but what if you were planning on retiring in the summer of 2020 and you had 60% in equities?

With this new understanding of bonds and equities, we can return to the topic of my book: The Lazy Portfolio. Why did the lazy portfolio become a staple in portfolio construction? Well, it’s right there in the name – because it takes a lot of data analysis and work to understand, track, and contextualize these nuances across all four markets, and many of my peers would rather hang their hats on archaic theories that were designed in a world that didn’t even have Internet. This enables them to justify putting their clients’ money on cruise control so that they can focus on acquiring new clients and making more money for themselves, rather than do the job that they were hired to do – which is make their clients more money.

While this is a Titanic tragedy for their clients (cue the string quartet playing as the ship breaks in half and begins to sink), this is a wonderful opportunity for us, because we do things very differently. We live in the 21st century and use global economic data to give us an up-to-the-minute perspective on the world economy – and then our work begins. NEST portfolios are dynamic, and work as hard as you do.

While our competitors are frozen in the icy Arctic, I’m swimming in spreadsheets of data, and I’ve got to say, the water is fine. If you want to discuss further, my door is always open. Join Dan and I on July 14th at 12:30PM CST to hear more.

Sean McDougle, CFP®
Chief Investment Officer & Partner, NEST Financial

We are here to inform you with real, non-bias investment education. DISCLAIMER: We are legally obligated to remind you that the information and opinions shared in this webinar are for educational purposes only and are not investment advice. For guidance about your unique goals, drop us a line at info@nestfinancial.net.