Why The 60/40 Portfolio Could Cost You Millions In Retirement

When I see people touting the 60/40 portfolio, I kind of feel like Haley Joel Osment’s character in the Sixth Sense. But instead of seeing dead people, I see dead ideas.

You probably know what I’m talking about: a portfolio that seeks to automatically balance risk by holding 60% stocks and 40% bonds.

This seems reasonable enough, but history shows that people who invest according to this rule have been leaving a lot of money on the table for a long time:

A quick look at US stocks, seen here in purple across the Vanguard Total Stock Market ETF (VTI

VTI
), and bonds, in orange across the Vanguard Total Bond Market ETF (BND

BND
), shows a problem. One of these funds is sleeping at work.

The problem comes from bonds, which have had an annualized return of about 2.6% over the long term, and US stocks, which have had an annualized return of 8.5% over the long term.

First, this shouldn’t shock anyone. The bonds are supposed to return less in the long term – after all, you are investing in it to get an income. But income is very valuable to many investors and therefore tends to generate a lower overall return over the long term. In contrast, the inherently higher risk of U.S. stocks produces higher returns.

The math here is simple: if we invested $1 million in US stocks and waited a decade, we would have $5.1 million in assets, based on the historical returns above. This is obviously much more than the $670,000 profit we will get from investing this money in bonds. Obviously a large bond portfolio is going to deplete our profits, which is why this is happening.

The 60/40 portfolio generated a profit, but a lower profit than the stock-only portfolio, by a mind-boggling $1,770,000!

By placing a heavy emphasis on bonds, we literally left almost $2 million on the table in a decade; the longer you devote yourself to the 60/40 portfolio, the more millions you miss.

The liquid alternative

The problem with stocks is: what happens if you can’t wait a decade? What if you need an income now? There is a simple solution: closed-end funds (CEF).

While the 60/40 portfolio is the old idea — which has been around for over 50 years — on how to earn income (by sacrificing total returns), CEFs are a much better idea: transform capital gains into a reliable source of income.

Take, for example, the 8% yield Royce Value Trust

Vermont
)an equity CEF that was launched in 1986 and has been generating income ever since.

Due to RVT’s high yield, you see your profits in the form of dividends which, in the case of this fund, are paid monthly.

RVT is also not a fly-by-night store. Not only does the fund’s history span nearly four decades (it was launched in 1986), but it is one of the largest equity CEFs on the market, managing more than $1 billion in assets for investors who can buy and sell their shares whenever they want.

That’s a clear benefit of investing in RVT, but here’s the thing: I don’t think it’s the best CEF on the market right now. There are literally dozens of better ones. But sometimes it is a strong buy, such as when its price suffers a sudden and significant discount compared to the net asset value (NAV, or value of its underlying portfolio).

At the moment this is not the case enough this time: Although the fund’s discount is at 11.5%, it has actually been much cheaper this year, reaching a low of 14.5% at the end of May.

This makes RVT not a bad thing choose today, but as I write this, about 90% of CEFs are trading at discounts, so we have plenty to choose from in the bargain bin!

The takeaway here is that once you look at the CEF universe, you start to see opportunities that go beyond capturing the profits that 60/40 investors miss. You’ll also learn how to create a diversified portfolio for all markets, as CEFs come from all kinds of sectors, while offering average returns above 7%.

So let’s throw the 60/40 portfolio in the trash and instead look toward the higher future income and gains that CEFs can offer.

Michael Foster is the senior research analyst for Contrarian perspectives. For more great income ideas, click here for our latest report «Indestructible income: 5 advantageous funds with stable dividends of 10.9%.»

Disclosure: none