ROOTS OF THE
60/40 SPLIT
Modern portfolio theory examines how investors can construct a portfolio using different asset classes to optimize returns for a given level of market risk. First introduced by economist Harry Markowitz in the 1950s, modern portfolio theory remains a mainstay of the investing and finance world today. Under modern portfolio theory, the 60/40 allocation of 60% stocks (equities) and 40% bonds generally has represented a typical starting point for bench marking risk tolerance. As people age and get closer to retirement, this allocation often shifts, becoming more heavily weighted to bonds than stocks.
Following modern portfolio theory, it would not be uncommon for a person nearing retirement to have a portfolio where the weighting of stocks and bonds is reversed: 60% bonds and 40% stocks. Why stocks and bonds? Risk and reward are generally positively correlated in investments. The higher the risk of loss, the greater the potential for reward. The lower the potential for loss, the lower the potential for reward. Stocks are both higher risk and higher reward. Bonds offer lower risk and lower reward. Additionally, bonds can provide a source of predictable income.
A NEW ASSET MIX?
Today, based on a variety of economic conditions, this mix of assets — stocks and bonds — is coming under increased scrutiny as an appropriate allocation for retirees. First, bonds aren’t the only income producing asset class that can be used to balance out the risks of stocks. Second, bonds are subject to certain economic factors, including inflation.
BOND BASICS
Bonds can help you add diversification and stability to your overall retirement strategy and are commonly considered less volatile than stocks. In fact, as interest rates have generally declined since the early 1980s, many bonds have provided solid long-term returns. However, while bonds can be an attractive addition to an overall retirement income strategy, they are not without risk. In fact, if you’re counting on bonds to help you save for retirement or to generate retirement income, you could find that their value has decreased when it’s time for you to cash in or reinvest in another bond. Bonds fluctuate in value in inverse correlation to changes in interest rates. When interest rates go up, a bond’s value goes down, and vice versa.
What is the impact under current economic conditions with increased interest rates? Bonds aren’t the only asset with less risk associated with market volatility and that can generate predictable income. Fixed index annuities are another option.
Download 'Annuities as an Asset Class' to learn more. What's Your Risk Number?
