In 1986, the S&P 500 Index price was at roughly 240 and the 10-year treasury yield was at roughly 7.5%. In the decades that followed, as the 10-year continued to decline to today’s historically low levels, we saw a win/win environment for both stock and bond markets, making a ripe playing field to generate attractive real returns in a traditional portfolio, which would most typically resemble a 60/40 (stocks/bonds) asset allocation mix.
During this time frame, bonds helped to level off the volatility of an overall portfolio and did well during economic downturns, acting as a hedge. They also added significant income, given prevailing interest rates at the time. Stocks have also been a great option historically, and started this era with the dividend yield on the S&P 500 averaging over 3.4%, while today it sits closer to 1.3%. It’s worth noting that there were very few other avenues for individuals to invest at the time. Only the largest institutional investors had access to what we now refer to as alternative investments.
Today, the traditional 60/40 mix faces new challenges. The stock market has experienced great returns and, as a result, starting valuations are above average. Bonds, the traditional income play, now yield just 0.2% (2-year treasuries) at the short end and 1.3% (10-year treasuries) on the intermediate side and, if rates rise, investors may lose principal if bonds are not held to maturity. Bonds are typically considered ‘safe,’ but also hold more risk due to the potential of rising interest rates.
Finding the Right Mix
Investors should hope to stay ahead of inflation and earn a long-term return on their investments to at least preserve purchasing power. Thus, equities remain an important part of the asset mix, but be sure to consider high-quality stocks. In many instances, quality can be evidenced by consistent cash flows, unique growth attributes, strong balance sheets or an attractive and growing dividend.
Given the current environment, investors might consider a lower-than-normal allocation to fixed income. Besides short- to intermediate-duration high quality bonds, ‘strategic’ income such as preferred stocks or alternative credit can be complementary and help with current yield, over time possibly even giving a better return.
With a smaller allocation going to fixed income, you might wonder where the remaining capital should go. We would suggest looking at alternative investments that are not as correlated to stocks and bonds. These alternatives can be strategies that ‘hedge’ market risk as well as real assets such as commodities, gold and real estate.
Regardless of where your exact asset allocation mix shakes out, and understanding that every investor has unique circumstances, the idea is to maintain long-term stock market exposure for appreciation potential, keep volatility in line with fixed income acting as a ballast and add alternatives that can contribute real returns to the portfolio, but in a way that is not highly correlated to the possible volatility of stocks or the interest rate sensitivity of bonds. In investing, you play the hand you’re dealt as effectively as possible with your ability, willingness and need to take risk always front of mind.