Investing using the 60 40 solution

French | Spanish | Portuguese | Italian | German | Japanese | Chinese | Korean | Russian | Arabic

THE 60/40 SOLUTION

The task at hand, and I can’t overstate how important it is, is how to divide up your long-term investment money, that is, money you’re not going to need to spend within a few years, between stocks and interest-earning securities. The “60/40 solution” is the basis upon which you and I can figure out how you should be allocating your money. By this I mean investing 60 percent of your long-term investment money in stocks and 40 percent in interest-earning securities.

Most of the studies on the subject of investment allocation have suggested that an investment mix of 60 percent stocks and 40 percent interest-earning securities is an excellent way for most investors to balance the two investment objectives of earning an inflation-beating return while not taking too much risk. If your investment diversification varies considerably from these parameters, you may be taking too much or too little risk. We’ll soon find out.

A 60 percent stock/40 percent interest-earning investment allocation is not cast in concrete. Rather, consider it a benchmark around which you customize your own diversification strategy. One major ingredient in coming up with a diversification model that fits you is how comfortable you are with investment risk.

What Kind of Investor Are You?

If you’re going to join the “sleep at night” investor club, you have to decide how comfortable you are with the inevitable fluctuations in stock and bond prices. Investors fall into one of three general categories depending on how well they can tolerate periodic dips in the value of their investments:

• An aggressive investor wants to achieve high long-term investment returns, even if that means that the investments will periodically experience heart-stopping short-term declines in value.

• A moderate investor wants to achieve a balance between earning attractive long-term investment returns and moderating periodic fluctuations in value.

• A conservative investor seeks stable growth in his investments, even if that means somewhat lower returns over time. A conservative investor is not as comfortable as other investors with the ups and downs of the stock market. If you’re inclined to prefer this classification because your investment portfolio is now a mere wisp of what it once was thanks to the credit crisis, bear in mind that this may not be the way you would like to invest over the next several years once the stock market gets back to normal, whenever that might be.

Investment Diversification Illustrations

Depending on whether you’re an aggressive, moderate, or conservative investor, here are examples of ways to allocate your investments. The essence of successful investing is to divvy up your money along the lines suggested here. Periodically rebalancing your investments, is icing on the cake. All this may sound complicated and time-consuming, but it isn’t. One other note before delving into the numbers: whenever you see the terms stocks and interest-earning, I mean either individual stocks and interest-earning securities or stock mutual funds and interest-earning securities mutual funds, like bond funds and money market funds.

Try to Be Consistent, Even during Periods of Maximum Pessimism

If you have the wisdom to devise and then stick with a sensible approach to investing, the biggest investment challenge you’ll have to confront from here on out is to avoid the temptation to

abandon your plan. The stock market has and will periodically scare the bejeepers out of you. All worthwhile long-term investments will occasionally lose value, and in the past it has sometimes taken years to recoup the losses. But patience is a virtue that should help you make up for lost ground and then some.

Tweaking Your Investment Allocation

The investment allocation summaries that are based on your risk comfort level provide ranges rather than fixed percentages. This gives you some wiggle room to tweak your allocation when you think investment conditions merit a bit of a change in your investments. After all, you need some peace of mind. For example, take the case of a moderate investor who was maintaining a 60 percent stock and 40 percent interest-earning allocation. The market is shaky, and the investor is getting uncomfortable. So she decides to move her allocation from 60 percent stock down to 50 percent stock, a move that will not radically change her allocation but will still make her more comfortable. This tweaking can work the other way as well. An optimistic investor who believes that stock prices are at bargain levels could increase his stock exposure without risking going overboard on stocks.

What’s Your Preference?

The primary advantage of investment allocation, and it is a huge advantage, is that it moderates the effects of big moves in the stock market. Should the weak economy continue to weigh on the stock market, the presence of interest-earning securities can reduce the impact of any further deterioration in stock prices on your overall portfolio returns. Including both categories of investments means that you’ll almost always have some money invested in a category that’s thriving without having too much money in

a category that’s diving. Here’s a revealing statistic: over the past 75 years, both stocks and bonds lost value in the same year only three times. The table below shows how important investment allocation can be. It assumes that the interest-earning portion of the portfolio earns 5 percent per year. Thus, an investor who has a 60 percent stock/40 percent interest-earning allocation during a year in which stocks take a 30 percent drubbing would have a

16 percent portfolio loss, about half the overall stock loss. Check this table against your desired allocation percentages to see how your investments would fare in both rising and declining stock markets. Chances are you’ll be pleasantly surprised.