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An Alternative to the 60/40 Portfolio

Ive made the argument lately that I think even if bonds perform poorly from their current low yields that they could still serve a purpose as a portfolio diversifier (see here andhere ).

Many readers have told me that, even though they understand the arguments Im making, it doesnt make sense to hold bonds in their portfolio. For some, holding cash or a cash equivalent like CDs makes more sense for their fixed income exposure based on their risk tolerance. Mixing cash with stocks is a barbell portfolio strategy with a very safe short-term capital preservation asset in one bucket and much riskier assets in another.

I have no problem with this strategy if thats what works for your situation. Theres no reason to try and implement a portfolio that youre not comfortable with. And a stocks and cash portfolio mix does have some backing from the investment community. The late-Peter Bernstein actually made the case for a 75/25 stock/cash portfolio in an article published in the Investment Management Review in the late 1980s:

Although cash tends to have a lower expected return than bonds, we have seen that cash can hold its own against bonds 30 percent of the time or more when bond returns are positive. Cash will always win out over bonds when bond returns are negative.

The logical step, therefore, is to try a portfolio mix that offsets the lower expected return on cash by increasing the share devoted to equities. As cash has no negative returns, the volatility might not be any higher than it would be in a portfolio that includes bonds.

Bernstein went on to show that up to that point, a 75/25 portfolio outperformed a 60/40 portfolio more times than not. I decided to run the numbers on this portfolio and compare it to the simple 60/40 stock/bond portfolio. Here are the results, broken out by decade, for a 75/25 portfolio made up of stocks and cash and a 60/40 portfolio made up of stocks and bonds*:

The 75/25 strategy slightly outperformed the 60/40 portfolio with higher volatility, but thats to be expected given the higher allocation to stocks. When both allocations were negative on an annual basis, the 75/25 portfolio lost an average of 12.1% while the 60/40 portfolio was down an average of 8.5%. The worst annual loss for 75/25 was -32.3% while the biggest annual drawdown for the 60/40 portfolio was -27.3%.

Larger gains and larger losses, basically what you should expect when you get rid of bonds and increase equity exposure. While the overall performance is interesting, what most investors are concerned about right now is a rising interest rate environment. You can see that the 75/25 outperformed in the 1950s and 1960s when rates rose (although the enormous bull market in stocks did much of the heavy lifting in the 50s).

Regardless of the strategy chosen, you can see that both have done fairly well over time even though there were a couple of poor performing decades. And these are both very simple portfolios. Investors can diversify globally and within each asset class as well to decrease the reliance on just the two broad assets used here.

The real benefit of diversification is to provide investors with an emotional hedge. If youre having a difficult time handling the potential risks from rising interest rates, it could make sense to have your safe bucket in cash as opposed to bonds. If you can stomach a little more volatility for a higher yield and potential stock bear market diversifier, bonds can still provide that function even if the returns are lower than theyve been in the past.

As with all asset allocation decisions, the numbers matter much less than your personal disposition and ability to stick with the one you decide on.

Further Reading:

*The 60/40 portfolio is comprised of 60% in the S&P 500 and 40% in bonds utilizing 10 year treasuries through 1975 and the Barclays Aggregate Bond Index thereafter. The 75/25 portfolio is made up of 75% in the S&P 500 and 25% in short-term t-bills.

This post from Ben Carlson (@awealthofcs ) originally appeared on A Wealth of Common Sense .