Many Ways to Under-perform a 60/40 - And How to Get Better

Nothing sounds easier than earning the return of a simple 60/40 strategy. Just buy two ETFs, 60% Stocks and 40% Bonds, for a combined fee of less than 15 basis points, re-balance quarterly and you are done, right? The reality for most investors could not be further from this.

Here are four ways investors typically under-perform:

  • Poor Timing outcomes

    It’s very hard to stick with the 60/40 static weights. The potential crash risk is high (for example -63% in 1932 and -33% in 2008), the pain of an extended drawdown is strong and the conviction in the buy-and-hold is weak (see more here), so investors try to do better by doing one of these timing moves that subtract value.

    • Letting weights drift - not re-balancing back to 60/40 after a drawdown

    • Under-weighting bonds because the rates are too low and are supposed to rise eventually

    • Making a short-term tactical allocation based on economic forecasts, or news and fears about “___” fill in the gap with the latest financial news headline

    • Contrarian tactical bets like over-weighting international stocks because they are cheap, or getting out of US equities because of the CAPE ratio

    • Using a dynamic allocation model with too much trend / strategy risk

    • And my favorite in this category: Reading a convincing and scary letter from a famous investor that you admire and deciding to go to cash

  • Chasing diversifiers
    Diversification looks great on paper. But in practice the concept is often used to ‘sell’ the latest hottest asset class. Diversification by itself can be very boring, but to make it fun (i/e reduce risk and increase return), the industry seems to package the latest “forward-looking thesis” with a great “backward looking” recent return (see more here).

    • A few examples from around 2006:

      • Emerging markets were going to take over the world, and so portfolio allocations moved from traditional 5% max to 20-30% range

      • The world was running out of oil, so you had to own a lot of it

      • Total unfunded liabilities of the US Government were unsustainable, inflation was coming and gold was the answer

      • Real estate never goes down, so you had to own REITs

    • Fast forward to post financial crisis:

      • MLP’s have a great ‘free lunch’ tax advantage

      • Inflation is surely coming now, so bet big on TIPs

      • Commodities and levered treasuries risk balance your portfolio

      • Hedge funds and CTA’s are the answer to the ‘next-2008’

      • Levered loans are a ‘no brainer’ at these low interest rates

      • And of course: harvesting risk premia and factor investing

    • All of these diversifiers might justifiably belong in a portfolio, but in most cases they are added or subtracted not solely based on diversification reasons (i/e reducing risk), but because of some implicit expected return view, which most often proves to be incorrect, and moves the actual returns further away from a simple 60/40.

  • Chasing Alpha

    • Same dynamics as above apply to chasing manager alpha. Many arguments exist about what styles of managers are about to do well but the vast majority of such views are not accurate. Moreso, most active managers unfortunately do not produce lasting alpha - all of which takes investor portfolios even further away from a simple 60/40.

  • Cash Flow Timing Gap
    Even if investors stick with a simple 60/40 allocation, they usually have cash on the side, or home equity, or some other assets that are not part of their 60/40 allocation, and so they decide to put more money in or take money out after they “watch” their 60/40 strategy.

    • As a result, investors are not earning a 60/40 return on their total wealth

    • Also, this cash flow timing produces a large gap between average time-series returns and the actual dollar-weighted IRR returns

    • On the order of magnitude, when compared to other costs, this gap can be called the “largest cost to investing,” very roughly averaging -3% per year. Recently, there was a wave of insightful critical questioning (for example here) of how this gap is computed and if it can exist in the first place. I am open to being persuaded, but so far, based on robust existing research (here), years of working with numerous families and my own behavioral tendencies, I remain convinced that the timing gap is real.

  • Fees
    A lot has been written on fees and the good news is that they are compressing but it is important to differentiate useless fees that don’t buy you anything from justified fees that deliver value. Understanding what you are paying for is key.

    • Financial Advisor fees

    • Product Fees

    • Trading and transaction Fees

    • Hidden Fees (here)

    • Government Fees (i/e taxes)

Many investors are trying to beat index-driven benchmarks. But given the long list of challenges above, I would suggest that trying to earn a simple 60/40 benchmark is already very hard. Even none of the famous IVY league endowments have outperformed it over the past decade (here and here). If your total wealth has compounded at the same dollar-weighted rates as a 60/40, you would be very successful already.

In order to get there, I suggest the following three steps:

  1. Stop subtracting value: think about the above ways in which you have subtracted value and try to avoid them in the future

  2. Find Your way: get to know your personal investing style and consistently apply it.

    • If you are a contrarian, risk manage your bets and stick with them. You will get paid eventually if you can withstand it

    • If you are a believer in passive and static - then hold on to those two ETFs and don’t get swayed by the temptation to time or chase diversifiers. Make sure you realistically assess the largest drawdown and the lowest 10-year returns that you can withstand and then check what these are for your chosen allocation over the long-run data

    • If you believe in a systematic dynamic approach that balances asset risk with strategy risk, then apply it consistently and you will succeed, because even if the model breaks and forecasts turn out to be random, you will still earn somewhere around the 60/40 which beats the alternative version of yourself managing wealth through time without a consistent approach

  3. Benchmark Smarter: Develop a better set of benchmarks

    • Evaluate your investment decisions compared to the initial plan. If you stuck with your investment process, that’s already a huge win as an investor.

    • Look at long-term return and risk targets and compare your total portfolio vs. original expectations. If you are within the risk-bounds, you are performing well, even if you are under-performing some index.

    • If benchmarking your total portfolio to an index, remember how difficult it is to actually earn the simple 60/40. Use index returns as an upper range rather than as the floor.