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The stock market is a great way to generate wealth, but it can sometimes be quite volatile. Investors who either lack the time or the risk tolerance to endure such volatility tend to look for safer strategies. This is what gives rise to strategies like the 60/40 portfolio.
Instead of investing the vast majority of your portfolio in stocks, you add a substantial bond allocation. In doing so, you add stability while still allowing your portfolio to grow over time. While this approach has its pros and cons, it can work well for the right investor.
What is a 60/40 portfolio
A 60/40 portfolio is generally one that has a 60% allocation to stocks and a 40% allocation to bonds. This gives you the growth potential of stocks combined with the stability of bonds, which tend to be less volatile.
In other words, adding a larger bond allocation can reduce some of the downside risk of an all-equity portfolio. This means that a 60/40 portfolio can be more resilient when the stock market drops.
The bond allocation of the 60/40 portfolio also provides investors with fixed income. Bonds are a form of debt, and investors receive regular interest payments. Stocks can pay interest as well in the form of dividends, but that isn’t always the case.
Pros and cons
As with all investment strategies, the 60/40 portfolio has its share of pros and cons:
- Diversification: This portfolio gives investors an easy way to diversify their portfolios across stocks and bonds. This can help mitigate risk, as the two types of investments can perform differently.
- Balanced returns: Stocks have high growth potential, while bonds provide stability and income. Combining the two can provide reasonable returns while reducing volatility.
- Simplicity: The 60/40 portfolio is a simple strategy that is easy for most investors to implement.
- Historical performance: The 60/40 portfolio has historically had solid returns and helped limit risk.
- May sacrifice returns: A 60/40 portfolio will typically outperform an all-equity portfolio while the stock market is down. However, equities tend to have better long-term returns than bonds. This means the 60/40 portfolio may sacrifice some returns for the sake of stability.
- Interest rate risk: Bond prices drop when interest rates rise, and these conditions can impact the value of the bond portion of the 60/40 portfolio, as it did in 2022.
- Changing market dynamics: Some experts believe that the traditional 60/40 portfolio may not perform as well in the future. This is due to low interest rates and the potential for lower returns from both stocks and bonds.
Who should use it?
Generally, this portfolio is the best match for those with relatively low risk tolerance and investors later in their careers. For example, middle-aged investors who don’t have decades to recover from a down market may benefit from the 60/40 portfolio.
In addition, those who have a moderate risk tolerance may prefer this portfolio. This is because the balance between stocks and bonds can provide reasonable returns while providing some protection from the volatility of the stock market.
Lastly, investors who want simplicity may prefer the 60/40 portfolio. This portfolio is simple to implement and manage. This makes it easy for the average investor to get started with a hands-off approach.
The 60/40 portfolio invests 60% in stocks and 40% in bonds. This approach provides investors with the growth potential of stocks with the added stability and income of bonds. Therefore, investors can achieve reasonable returns while keeping risk under control. This makes it ideal for investors in the middle of their careers and those with moderate risk tolerance.
However, investors should understand that they may sacrifice some returns, as stocks have historically outperformed bonds. Still, the 60/40 portfolio is a strong strategy overall. For the right investor, it can provide the desired results while taking a hands-off approach to investing.