Wall Street Journal still pushing the 1930 60-40 strategy and its mere 5% returns
Posted by John Reed on
Another WSJ article today lauding the “woundrous” 60-40 strategy. 60% stocks and 40% bonds. It is supposed to do better than any other type of investment portfolio. I think continued belief in this nonsense is “wondrous.”
1. Does it generate commissions to securities dealers? Initially I guess, if you buy it then leave it alone to avoid management fees and gains taxes.
2. Decisions and forecasts must be judged by what the investor knew at the time, not what the results were in the retrospectoscope.
3. Bonds in 2023 are an entirely different animal than they were before the Great Depression. In 1933, the US debt-to-GDP ratio was 17%. Today, it is 128%, an all-time record. There was no danger of hyperinflation in 1933; enormous risk today. Bonds during inflation are like houses made out of sugar in a hurricane. We do not need to look at the historic record to verify that. It is 2+2 = 4.
.
Also, it use to be normal for many corporate bonds to be honestly rated AAA. “There were well over 60 publicly available investments in companies that were rated as AAA in their debt issuances during the early 1990s. As of June 2020, only two companies remain with a AAA credit rating – Johnson and Johnson and Microsoft.”
.
In the 1980s, leveraged buyouts were popular. These are like you own a free-and-clear home. A stranger wants to buy it, and can use your equity to finance the purchase. So he gets a 100% mortgage on your home and give you the proceeds and evicts you.
.
That cannot be done with a private home, but it can be done with a publicly-traded company—hostile takeover. Before the 1980s, a corporation with a AAA credit rating was considered well- and conservatively-managed and very strong financially. But during the 1980s, having such a corporation came to be a good way for the top executives to get fired,
.
One of my Harvard Business School classmates wrote a book about private equity and she said the acquirer needed to “make the equity sweat.” In other words, no debt means your management of the corporation is too conservative. Not trying hard enough. Not sweating.
.
So before the Depression, a 60-40 portfolio may have made sense because the AAA-rated bond companies could withstand the downturn in economic activity and continue to pay the promised interest on their bonds. That was a nice diversification so stocks would do well in boom times and AAA bonds would do well in recessions.
.
In 2023, there are only two AAA corporate bonds: Microsoft and Johnson & Johnson. But that is not a very diversified portfolio. When my wife graduated from college, she went to work for Penn-Central Railroad which was AAA. Weeks after she started they, they defaulted on their bonds, which is about a ZZZ-rating.
.
4. The WSJ article says the 60-40 is producing a 5% return, which they say is great considering the current market. It is less than the inflation rate for Chrissakes.
.
5. I came from real estate investment to the Harvard Business School. HBS is not a real estate investment school. It is about corporations and its finance courses are about stocks and bonds.
.
One of the greatest forces for making money in real estate is leverage. That is just the simple mathematical consequence of having a mortgage. You buy a $500,000 house with $100,000 down and a $400,000 mortgage. If the property appreciates 8.4%, which US home prices did from the end of 2021 to the end of 2022, Your equity grows by 8.4% x $500,000 = $42,000.
.
That beats the hell out of the 5% the WSJ is excited about in the 60-40 portfolio. But look at the return on your equity: $42,000 ÷ $100,000 = 42%.
.
Is real estate leverage a two edged-sword? It can be. Leverage multiplies your rate of return, including when it is negative. If your $500,000 house drops in value, say, 5%, you lose 5% x $500,000 = $25,000, but that is $25,000 ÷ $100,000 = 25% of your equity. Ouch.
.
But as I said in my most recent book, there are about two dozen structural reasons why homes do not suffer such things very often. One is NIMBYism, Not In My Backyard resistance to any competitive building in the area. Another is ever more strict building codes that allow the existing buildings to remain exempt from the newer codes.
.
The other twenty something advantages involve extraordinary laws and rules designed to favor home ownership like the $250,000 per spouse capital gains tax exclusion in IRC §121 for principal residences. That is a big help to your return that you do not get even a hint of in a 60-40 portfolio.
.
The 60-40 portfolio seems an aboriginal idea that could make sense to some isolated mountain tribe that had never seen a home or more specifically the American principal residence and all its advantages in 2023. I will leave it to the WSJ to explain how they can have such nutty holes in their investment game when they, themselves, probably have lived in an American principal residence for decades.
.
????
1. Does it generate commissions to securities dealers? Initially I guess, if you buy it then leave it alone to avoid management fees and gains taxes.
2. Decisions and forecasts must be judged by what the investor knew at the time, not what the results were in the retrospectoscope.
3. Bonds in 2023 are an entirely different animal than they were before the Great Depression. In 1933, the US debt-to-GDP ratio was 17%. Today, it is 128%, an all-time record. There was no danger of hyperinflation in 1933; enormous risk today. Bonds during inflation are like houses made out of sugar in a hurricane. We do not need to look at the historic record to verify that. It is 2+2 = 4.
.
Also, it use to be normal for many corporate bonds to be honestly rated AAA. “There were well over 60 publicly available investments in companies that were rated as AAA in their debt issuances during the early 1990s. As of June 2020, only two companies remain with a AAA credit rating – Johnson and Johnson and Microsoft.”
.
In the 1980s, leveraged buyouts were popular. These are like you own a free-and-clear home. A stranger wants to buy it, and can use your equity to finance the purchase. So he gets a 100% mortgage on your home and give you the proceeds and evicts you.
.
That cannot be done with a private home, but it can be done with a publicly-traded company—hostile takeover. Before the 1980s, a corporation with a AAA credit rating was considered well- and conservatively-managed and very strong financially. But during the 1980s, having such a corporation came to be a good way for the top executives to get fired,
.
One of my Harvard Business School classmates wrote a book about private equity and she said the acquirer needed to “make the equity sweat.” In other words, no debt means your management of the corporation is too conservative. Not trying hard enough. Not sweating.
.
So before the Depression, a 60-40 portfolio may have made sense because the AAA-rated bond companies could withstand the downturn in economic activity and continue to pay the promised interest on their bonds. That was a nice diversification so stocks would do well in boom times and AAA bonds would do well in recessions.
.
In 2023, there are only two AAA corporate bonds: Microsoft and Johnson & Johnson. But that is not a very diversified portfolio. When my wife graduated from college, she went to work for Penn-Central Railroad which was AAA. Weeks after she started they, they defaulted on their bonds, which is about a ZZZ-rating.
.
4. The WSJ article says the 60-40 is producing a 5% return, which they say is great considering the current market. It is less than the inflation rate for Chrissakes.
.
5. I came from real estate investment to the Harvard Business School. HBS is not a real estate investment school. It is about corporations and its finance courses are about stocks and bonds.
.
One of the greatest forces for making money in real estate is leverage. That is just the simple mathematical consequence of having a mortgage. You buy a $500,000 house with $100,000 down and a $400,000 mortgage. If the property appreciates 8.4%, which US home prices did from the end of 2021 to the end of 2022, Your equity grows by 8.4% x $500,000 = $42,000.
.
That beats the hell out of the 5% the WSJ is excited about in the 60-40 portfolio. But look at the return on your equity: $42,000 ÷ $100,000 = 42%.
.
Is real estate leverage a two edged-sword? It can be. Leverage multiplies your rate of return, including when it is negative. If your $500,000 house drops in value, say, 5%, you lose 5% x $500,000 = $25,000, but that is $25,000 ÷ $100,000 = 25% of your equity. Ouch.
.
But as I said in my most recent book, there are about two dozen structural reasons why homes do not suffer such things very often. One is NIMBYism, Not In My Backyard resistance to any competitive building in the area. Another is ever more strict building codes that allow the existing buildings to remain exempt from the newer codes.
.
The other twenty something advantages involve extraordinary laws and rules designed to favor home ownership like the $250,000 per spouse capital gains tax exclusion in IRC §121 for principal residences. That is a big help to your return that you do not get even a hint of in a 60-40 portfolio.
.
The 60-40 portfolio seems an aboriginal idea that could make sense to some isolated mountain tribe that had never seen a home or more specifically the American principal residence and all its advantages in 2023. I will leave it to the WSJ to explain how they can have such nutty holes in their investment game when they, themselves, probably have lived in an American principal residence for decades.
.
????
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