Ye Olde Pie Chart? Perhaps It’s Time to FugetaboutitAdvice to the Advisor
The old rule of thumb for asset allocation—the one many investment clients used the fix on—was subtracting their age from 100 to learn the percentage of their portfolio that belonged in stocks. (CNN Money now points out that, with Americans living longer and longer, a more appropriate calculation would use the number 110 or even 120 minus their current age!)
That calculation may have been primitive and one-size-fits-all, but the concept, of course, was solid. The whole idea behind asset allocation is to prevent extremes. Experience has taught investors and advisors alike that the three main categories of investment assets—equities (stocks), fixed-income (bonds), and cash equivalents each behave differently in reaction to any given set of circumstances, a phenomenon called “negative correlation.”
Investor.gov, the website of the U.S. Securities and Exchange Commission, uses an amusing but rather apropos simile, Ye Olde Pie Chart, explaining asset allocation by comparing it to street vendors who sell both umbrellas and sunglasses—two items consumers are unlikely to purchase at the same time. The vendors know that, when it’s raining, umbrellas will be in demand; when it’s sunny, the glasses will become the hot item. By diversifying, the vendors reduce the risk of losing a lot of money on any given day.
As investment advisors, we’re finding that in recent years the asset allocation balancing act has become trickier, with the most noticeable change being in the area of fixed income. With interest rates so low, investors can no longer look to bonds as a source of steady, “low-risk income” when stock prices fall. In fact, with near-negative interest rates, many investors literally cannot afford to own bonds. As a result of the lack of current yield on fixed income investments, Sheaff Brock Managing Director Dave Gilreath points out, what we are seeing in place of the “push-and-pull” effect of negative correlation is a trend towards positive correlation between stocks and bonds. Reality is, Gilreath writes in Financial Advisor, “the behemoth tech stocks driving the market are trading more or less in tandem with bonds.” Should stock shares “go south,” he cautions, “bonds offer little in the way of a reliable cushion.”
That traditional 60/40 portfolio allocation (or whatever the 100 minus-age calculation dictated) may have been fine for past generations, but given today’s historically low interest rates and ever-lengthening life expectancies, asset allocation needs a new formula in order for clients to have a chance at building an adequate income in retirement.
The solution? Ironically, Gilreath posits, it may lie in hedging stock risks with other stock risks. To counter the positivity in correlation between stocks and bonds, he suggests substituting shares of value stocks that generate reliable dividends. Carefully chosen large, midcap, and small-cap value stocks may provide bond-like correlation while paying several times the yield of high-quality corporate bonds.
Ye olde pie chart? The olde arithmetic? It may be time to fugetaboutit!