Beyond the 60/40 Portfolio

How do you determine the right mix of investments for your portfolio? The 60/40 portfolio—a classic allocation of 60% stocks and 40% bonds—is often touted as the gold standard for retirement planning. While it’s a simple and widely-used strategy, it’s also a broad, one-size-fits-all rule that misses a lot of nuance. Many people unknowingly rely on this conventional wisdom, but there’s a better way to approach your investment mix.

Rethinking Risk and the 60/40 Portfolio

When most people think about the risk in their portfolio, they focus on asset allocation. Aggressive investors with high risk tolerance typically hold a larger proportion of stocks, while conservative investors lean heavily on fixed income. For example:

• A 60/40 portfolio is often suggested for retirees.
• A more conservative investor might opt for a 50/50 or 40/60 split.
• Aggressive investors could aim for an 80/20 or even 100% stock portfolio.

While these rules of thumb provide a starting point, they fail to account for your unique financial situation and emotional readiness for risk. Before determining the right mix for your portfolio, it’s crucial to understand what risk really means.

What Real Risk Is

Risk is often viewed as the potential to lose money, and this perspective can evoke fear. Stories of investors losing everything in corporate bankruptcies like Enron or Lehman Brothers linger in our collective memory. While these are examples of permanent loss, they represent only one type of risk.

The second, and far more common, type is portfolio value decline. This occurs when the market temporarily dips, affecting the value of ETFs or mutual funds. For instance, the S&P 500 would require all 500 companies to go bankrupt simultaneously for you to lose your money permanently—a highly unlikely scenario. However, the real challenge with temporary declines lies in how investors react. Emotional responses like panic selling can turn temporary losses into permanent ones, which is why this risk deserves as much attention as permanent loss.

The 60/40 Portfolio: A Good Starting Point

The 60/40 portfolio assumes that a general mix of stocks and bonds will work for most retirees, but everyone’s financial situation and emotional capacity for risk are different. To create a portfolio tailored to your needs, focus on two critical components: risk capacity and risk tolerance.

Risk Capacity: How Much Risk Can You Afford?

Risk capacity refers to your financial ability to withstand market declines without jeopardizing your goals. It’s a quantitative measure and doesn’t depend on your emotions. The best way to calculate your risk capacity is to develop a clear retirement income plan.

Based on that plan, it should be fairly easy to figure out what your distributions will be over the next 5 years. This is the minimum amount of fixed income you should hold. 

For example, if your retirement plan shows you’ll need $250,000 over the next five years, that amount should be allocated to low-risk fixed assets.

To see more about this approach, read A Smarter Way To Manage Retirement Income

Risk Tolerance: How Much Risk Can You Emotionally Handle?

Risk tolerance is your emotional and psychological comfort with market declines. Unlike risk capacity, it’s highly subjective and can change based on external factors like market performance or personal circumstances. To determine your risk tolerance, it helps to think in terms of dollars rather than percentages.

I call this your "freak-out number":

• Start with your portfolio’s total value. For example, let’s say you have $2,000,000.
• Ask yourself: At what dollar loss would I start to worry? Would a $200,000 (10%) decline make me nervous? What about $400,000 (20%)?
• Next, identify your breaking point—the amount of loss that would make you call your advisor or sell everything.

By answering these questions, you can identify your emotional threshold and adjust your portfolio to align with it.

Behavioral Biases and Risk 

Behavioral biases like recency bias can distort risk tolerance. When markets are performing well, investors often overestimate their ability to handle declines. Conversely, during market downturns, fear can lead to rash decisions. These emotional swings underscore the importance of balancing your willingness to take risk with your financial capacity to do so.

Going Beyond the 60/40 Portfolio

To go beyond the 60/40 portfolio, your investment strategy should be tailored to both your financial needs (risk capacity) and emotional comfort (risk tolerance). Here’s how to get started:

1. Create a Retirement Income Plan
   Use tools like Boldin (formerly New Retirement) or consult a financial planner to develop a plan that clarifies your financial goals and identifies your risk capacity.

2. Incorporate Fixed Assets Strategically
   Ensure your portfolio includes at least the minimum amount of fixed assets required to cover your planned withdrawals over the next five years. From there, adjust based on your risk tolerance.

3. Assess and Monitor Regularly
   Both your financial situation and emotional outlook may change over time. Regularly review your portfolio and update your plan to reflect your evolving needs.

The 60/40 portfolio may be a good starting point, but it’s far from a one-size-fits-all solution. By understanding the nuances of risk—both financial and emotional—you can create a portfolio that truly aligns with your unique situation. Focus on balancing your risk capacity and risk tolerance to ensure your investments are tailored to your needs, not just conventional wisdom.

If you’re unsure where to start, consider working with a qualified financial planner. Look for someone who:

• Is a CFP® 
• Specializes in working with retirees
• Operates on a fee-only basis without selling products

Your portfolio should reflect your goals, comfort level, and financial reality. By moving beyond the 60/40 portfolio, you can build a strategy that works for you today and in the years to come. If we can help, don't hesitate to get in touch.