Do you need more stocks?

The 60/40 asset allocation is a well-recognized benchmark for splitting stocks and fixed income in a portfolio. Investing 60% in equities and 40% in bonds has a “rightful place as the centre of gravity of asset allocation for long-term investors,” wrote investment guru Peter Bernstein back in 2002.

But is that still an ideal split in today’s ultra-low interest rate environment? Historically the 60/40 allocation married high-return high-risk stocks with stable, moderate-return bonds to provide decent and resilient returns over-all. While bonds still provide stabilizing power, they can’t be expected to provide much return with interest rates so low. Bonds are also at risk if interest rates rise gradually and cause modest capital losses. It might make sense to rethink your asset allocation in light of current circumstances.

Yielding to a dilemma: No question low bond yields create a dilemma. With yields so low, it becomes harder to meet your return objectives, which might force you to save more, work longer or spend less in retirement. But adding stocks to boost returns can also imperil your nest egg if markets tank.

• How high-yield bonds can sink your profits »

Despite the risks, some experts think the current situation calls for a bump up in equity allocation. Fiera Capital, chaired by prominent investor Jean-Guy Desjardins (a recipient of the CFA Institute’s Award for Professional Excellence), suggests considering a split of 75% equity and 25% fixed income and cash in place of 60/40. “The tides have changed very significantly here,” says Candace Bangsund, Fiera Capital vice-president and portfolio manager global asset allocation. “We’re in this environment with ultra-low rates where in our view rates have nowhere to go but higher.” (Bonds prices fall when interest rates rise. While most economists don’t think rates will spike any time soon, the possibility of modest and gradual rate rises is a significant risk.)

Other experts are more cautious. “If an investor had determined that an asset allocation was appropriate for their risk/return goals, we would caution against changes in response to the yield environment because generally that involves taking on greater risk,” says Todd Schlanger, senior investment strategist at Vanguard Investments Canada.

Before bumping up equities, carefully consider the possible impact it might have in the next stock market downturn. Keeping a watchful lookout for rising threats to stock markets might give you time to move some money back to bonds before a full-scale stock market meltdown, but don’t expect to escape unscathed. Unless you are a market genius, other investors would likely see the same warning signs and stock prices would react before you could adjust. You just can’t expect to time the markets, at least with any prescience or precision, and equity’s risks are largely inescapable once you commit.

Assuming the risk: The 60/40 split is meant to represent a fairly middle-of-the-road benchmark for long-term investors, but the ideal ratio will vary for each individual. The right asset allocation must fit your objectives, risk-return profile, time horizon and other circumstances. Risk tolerance is determined by both ability to assume risk based on financial circumstances and your willingness to assume risk as determined by your frame of mind. “Portfolio volatility and risk is a matter which is very much personalized to the individual investor,” says Mark Allen, vice-president equities at RBC Wealth Management. Generally, your ability to assume risk is greater in your early years and decreases with age, but there is lots of variation. (Next issue we will discuss asset allocation specifically for retirees and near-retirees.) Time horizon is critical, since you must be able and willing to wait out market downturns.

• Squeeze out more yield »

It’s hard to know in advance how you would react when markets turn nasty. It helps to envision a scenario in which your stocks fall 40% to 50%, while your investment-grade bonds remain unaffected (similar to what happened in 2008-2009). If you have a 60/40 asset allocation, your stocks fall 45%, and your bonds are entirely investment grade, then your portfolio decline is 27%. If you have a 75/25 asset allocation, then your portfolio would drop 34%. Faced with that scenario, you need both a resilient financial situation and the personal fortitude to stick with stocks and not sell in a panic, which would be one of the most serious investment mistakes you could make. Ideally you should view market downturns as a good time to buy stocks cheaply. If you’re not willing to wait out a big market decline, then go for a more conservative asset allocation.

Takeaway: With interest rates so low, it might make sense to bump up your equity allocation above the traditional 60/40 benchmark. But the asset allocation you choose must fit with your objectives, personal situation, time horizon as well as your ability and willingness to tolerate the added risk of higher stock exposure.

Finding more reward without too much risk