Conventional wisdom says that investors should hold a combination of stocks and bonds in their portfolio. Stocks provide the greatest upside potential, while bonds provide a hedge against market downturns. The 60/40 strategy has become one of the most popular pieces of advice from the era, recommending that investors hold 60% stocks and 40% bonds.
Let’s take a look at why the strategy may not be as effective moving forward and some alternatives to consider.
Interest Rates Skew Risk/Reward
The 60/40 strategy was successful over the past two decades thanks to falling interest rates boosting bond prices. With interest rates at record lows around the world, bondholders have higher risk and lower returns expectations. The risk is that interest rates rise from these levels — hurting bond prices — whereas returns are anchored by low interest rates.
10-Year Treasury Interest Rates Over Time – Source: FRED
Interest rates have stabilized near record lows over the past seven years, which has already depressed bond market returns. For example, the Barclays Aggregate Bond Index returned less than three percent over the period. The S&P 500 index more than doubled over the same timeframe, which means bond investors had a significant opportunity cost.
Many experts believe that low interest rates are here to stay. After more than a decade of economic expansion, interest rates have risen to a paltry percentage of their prior highs. The European Central Bank is facing similar issues overseas, but with rates already near zero, the central bank is considering moving them back into negative territory.
Stocks Aren’t a Viable Alternative
Investors may be tempted to allocate more capital to stocks to offset exposure to the troubled bond market, but stocks could be nearing the end of their own ten-year bull market. For instance, the Shiller Price-Earnings Ratio stands at 31.07x, which is greater than it was prior to the 2008 financial crisis and Black Tuesday (the 1929 stock market crash).
The Shiller PE Ratio – Source: Multpl
While stocks may seem overpriced, many studies have shown that trying to time the market results in lower returns than taking a buy-and-hold approach. Investors shouldn’t simply liquidate their portfolio into cash and wait on the sidelines — they could miss an even larger bull market before there’s any significant decline in the equity market.
According to Betterment, time in the market is much more important than market timing when it comes to overall performance. After analyzing S&P 500 returns between January 1928 and 2014, the company found that the risk of loss dramatically decreases over the long-term from 26.4% after 12 months to just 4.1% after 12 years.
Generating Income from Stocks
A smarter approach may be generating income from stocks rather than bonds using covered calls. By taking this approach in lieu of holding bonds or staying in cash, investors can generate income during retirement, avoid holding bonds, continue to benefit from higher return expectations of stocks and hedge against the risk of a decline in equities — all at the same time.
Lattco Automated Trading System Dashboard – Source: Lattco
The Snider Investment Method makes it easy to build a diversified portfolio of high-quality stocks that offer high income potential for covered call options. If you’re just getting started, you can enroll in our Snider Investment Method Fast Track Online Course to learn our strategy. The course includes access to our Lattco automated trading software to screen, trade, and manage positions.
Our approach answers many common questions that come up when using covered calls:
- What stocks are best suited for covered calls?
- What strike price and expiration should you use?
- How much should be allocated to a particular position?
- What should you do if the stock appreciates in price?
- What should you do if the stock falls in price?
- How many contracts should be sold against the stock?
We have refined our strategy for more than a decade and developed the automated software necessary to bring the strategy to everyday investors.
Alternative Ways to Hedge Risk
Covered calls provide one of the best ways to hedge against risk by generating an income in retirement while maintaining exposure to equities. However, there are other strategies that investors may consider if they aren’t permitted to trade options or they would prefer to use equity-only strategies when limiting their risk to bonds and underperforming equities.
Some of the most popular options are:
- Additional Asset Classes like real estate and commodities provide great diversification along with high return expectations. They also have a low correlation to bond and stock returns.
- Treasury Bills yield nearly as much as long-term Treasuries, which makes cash-equivalent funds could be an alternative to investors that are more concerned with capital preservation than realizing an optimal return on investment.
- Hedged Equity Funds seek to reduce the volatility of a stock portfolio using a variety of different strategies. If an investor is approaching retirement, these funds could be an attractive way to reduce risk.
The Bottom Line
The 60/40 strategy doesn’t provide the same risk/return profile as it has over the past 40 years. With low interest rates, bondholders are realizing low returns with high risk from a potential increase in interest rates. These dynamics suggest that investors should look elsewhere for safer returns, such as covered call options.
Before investing in any of these strategies, it’s a good idea to speak with a financial advisor to determine how they will affect your retirement planning. The best choice depends on your risk tolerance, target returns and other factors.
Sign up for a free Snider Investment Method e-course to learn more about the strategy today!