Suggestions for Customizing the 60/40 Portfolio (and Other Allocations)

The 60/40 allocation has historically proven to be a good overall allocation for many investors. It has generally cushioned some of the blow from large drops in stock prices.

A traditional 60/40 portfolio comprises 60% large-cap stocks and 40% investment-grade bonds. Though this approach holds two historically uncorrelated asset classes, there are ways to diversify it further. In this week’s Investor Update, I offer suggestions for how you can customize it—or any other allocation mix of stocks and bonds. In other words, the suggestions here can be applied to various allocation mixes of stocks and bonds (or stocks and so-called safe assets).

Customizing the Equity Side of a 60/40 Portfolio

Diversify the Equity Categories—The moderate AAII Asset Allocation Model, which uses a 60/40 mix, diversifies away from solely holding large-cap stocks. Rather, it holds a mix of large-cap, mid-cap and small-cap domestic stocks as well as international developed and emerging market stocks. This diversifies the equity across both size and country. (Our aggressive and conservative allocation models also diversify across asset class categories.) 

Use Factors—The 60% portion can also be adjusted by using factors. This would involve incorporating value, momentum, size and/or quality factors. Rather than holding a traditional S&P 500 index fund, you would hold, say, a value-oriented fund or use a value-oriented approach to selecting stocks. You could also tilt your portfolio toward a certain factor by mixing a traditional index fund with a factor-based approach.

Boost the Yield—If realizing a higher level of portfolio income matters, dividend stocks can be emphasized. Likewise, real estate investment trusts (REITs) or master limited partnerships (MLPs) could be utilized. This would maintain the equity allocation at the desired level while supplementing the portfolio income generated by the fixed-income side.

Customizing the Bond Side of a 60/40 Portfolio

Change the Maturities—The moderate and conservative AAII Asset Allocation Models allocate to both short-term and intermediate-term bonds. Doing so results in less interest rate sensitivity than a traditional 60/40 approach, which typically borders between intermediate-term and long-term bonds.

Get Some Inflation Protection—Those concerned about inflation can opt for Treasury inflation-protected securities (TIPS). The principal of TIPS changes with inflation. It rises when the consumer price index (CPI) increases and falls when the CPI decreases. The Treasury’s Series I bonds also adjust to inflation, but the $10,000 limit on purchases (per person, per year) makes it difficult for investors with significant savings to have a meaningful allocation to them.

Build a Bond Ladder—A bond ladder involves holding bonds with different maturities. This helps to offset the timing risk of interest rates. In rising interest environments, it also can provide you with proceeds to reinvest at higher rates. Defined-maturity bond funds can be used instead of individual bonds.

Allocate to Cash—You won’t earn much interest income, but cash provides liquidity and does not lose value on a nominal basis. (It does lose value on a real, meaning inflation-adjusted, basis.) Allocating some of the 40% portion to cash can be particularly useful to retirees as a buffer asset to tap when other asset classes are down.