This month, Peter Mallouk and Jonathan Clements offer their take on the classic 60/40 portfolio, discussing the relative merits of bonds, U.S. stocks and international shares. Plus, learn how timing your charitable donations can potentially result in a larger tax break.
Hosted by Creative Planning Director of Financial Education, Jonathan Clements, and President, Peter Mallouk, this podcast takes a closer look into topics that affect investors. Included are in-depth discussions on financial planning issues, the economy and the markets. Plus, you won’t want to miss each of their monthly tips!
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Transcript:
Jonathan Clements: Hi, this is Jonathan Clements, Director of Financial Education for Creative Planning. With me is Peter Mallouk, President of the firm, and we are down the middle. If you kick around Wall Street for long enough, you’ll hear the same old debates rehashed again and again. For instance, back in late 2019, some major brokerage firms declared the death of the classic balance portfolio with a mix of 60% stocks and 40% bonds. Well, guess what? We’re hearing that again after 2022’s market dropping, some market strategies are saying that bonds are more attractive now that yields are higher. That makes sense to me. But Peter, these strategists are also urging investors to up the percentage of their portfolio that’s in bonds at the expense of stocks after 2022’s stock market decline. Does that seem like a good idea? Wouldn’t folks be potentially lightening up on stocks at a terrible time? If you’re going to make a radical portfolio change, wouldn’t it make more sense to throw bonds out of the portfolio?
Peter Mallouk: Jonathan, I’ve never been a big fan of just the automatic 60/40 portfolio, which is the portfolio that a lot of people just automatically go into it. Traditionally, historically, and I remember maybe five years ago or so, I was on a Jeremy Siegel podcast and I suggested that this was a really bad idea and the 60/40 portfolio was dead. And that’s become a very common comment over the last few years. And the reason I had said that is bond yields were below 2%, right? Dividends from stocks were around 2%, and of course stocks come with volatility, but if you hold stocks for five to 10 years, your odds of having a positive return are overwhelming, way over 90%. And if you’re getting a yield equal or sometimes even better than high quality bonds and you get the capital appreciation over time, of course stocks are the better investment.
But really my issue with the default bond portfolios is that they don’t really tie back to a human being and their goals. I really like to look at the allocation as being driven by need. I think it’s a mistake when we default to a traditional 60/40, or for that matter, if we default to a portfolio based on someone’s risk tolerance. Hey, you’re moderate risk. You should get 60/40 or you’re aggressive, you should be 80% stock. And we should get away from doing it based on age. Like one of my idols, John Bogel was a believer in using age. If you’re 70 years old, 70% bonds, right? And it just seemed like a little over the top. The way I think it should be is based on your goals. Over the long run, we think stocks are going to do better than bonds.
For the part of your portfolio that’s there to serve you for the long run, five years or more, seven years or more, 10 years or more, that should be more in stocks and assets like that where you’re an owner and we’re very, very likely to be rewarded for that. And money you need in the next couple years, regardless of how you feel about valuations or yields, they should be in things like high quality bonds that are relatively stable and we can rely on them to meet your short term needs. I’m a big believer on making the allocation, that first critical decision in portfolio construction, based on needs. And as you see the spread in bond yields from stock market expected returns, when you see that very wide, it’s very, very hard to justify a lot of bonds. You really only want the bonds that you need.
Bonds have become more attractive; yields have doubled in the last year. It’s enticing people back over to the bond market. I still think people shouldn’t go over there for the yield. They should go over there only to cover their short-term needs because the stock market’s in bear market territory; we know when the bear market turns around, which no one knows when that will be, the expected returns are in the double digits for the next five years. That’s traditionally what happens. Don’t be tempted to chase that bond yield; stay with your needs, what you need over the short run, bonds. What you need over the very long run, stocks.
Jonathan: Yeah. Just to sort of back up what you’re saying, Peter, when I think about the bond allocation, two principles in mind, one is that if I’m going to take risk, I want to take risk on the stock side of the portfolio because that is going to be your portfolio’s engine of growth. And the more you have in stocks, the higher your portfolio’s expected rate of return. And two, again, to sort of back up what you’re saying, when I think about how much to have in bonds as somebody who’s on the cusp of retirement, I think about, “Well, okay, how am I going to pay for the next five years?” If you use the 4% rule, and I’m not necessarily saying that’s the right rule, but if you’re using 4% or so as your withdrawal rate, you’re looking for five years, that’s 20% of your portfolio in bonds and the other 80% can potentially be in stocks. Now, I have personally very high risk tolerance. I’m happy to have 80% of my portfolio in stocks. So that’s where I am, even though I am on the cusp of retirement; other people may be more nervous about the stock market and want to have a lower percentage in stocks, but purely from a needs point of view, as somebody on the cusp of retirement, I’m not sure you need more than 20% of your portfolio in the bond market. What are you thinking about that, Peter?
Peter: Well, all I’m thinking about is that I’m finding out on our podcast that you’re on the cusp of retirement.
Jonathan: I’m not about to abandon you, Peter. I’m happy to get on and talk to you once a month.
Peter: Fantastic. I do agree that the bond side, there are all kinds of bonds, right? Bonds are just loans. High yield bonds are basically junk bonds. They entice you with even higher yields or in most markets, the longer you loan money, the higher the yield you’ll get. But really the part of the portfolio to take your risk is on the stock side. Accept the volatility there. When you’re on the bond side, focus on quality. And even if you’re on the cusp of retirement, having a lot of money in stocks can make a ton of sense because it used to be, in the 1950s when people retired, the average length of retirement was zero years. You basically retired and then you died. Life expectancy was in the sixties. Now the average retirement is decades. It’s not like you retire and magically you need all of the money in your portfolio. The portfolio still has to go on for decades. It has to fight off inflation. You have to have stocks to do that. That allocation, even for somebody on the cusp of retirement, can still be very heavily in stocks. Even if somebody doesn’t have a high risk tolerance, they should consider it.
Jonathan: Having decided what percent of your portfolio you’re going to have in stocks then comes to the all-important question. How are you going to divide your money between U.S. and foreign shares? And of course this has been a hot issue for years and years and years and of late, a lot of people have tilted heavily toward the U.S. for one simple reason. The U.S. has done well. But of course, one thing we know about investing is you shouldn’t drive looking in the rearview mirror. And indeed, after a decade of retro performance, foreign markets are now showing signs of life. International stocks outpaced U.S. stocks in 2022, and they have so far in 2023. If you were talking to an investor that they were asking about their foreign stock allocation, what would you say to them, Peter?
Peter: Well, what a hot topic, and this has really been a topic I haven’t been able to get away from my entire career. If you look at 2000 to 2010 international stocks and emerging market stocks, they just had an amazing run for that decade. And the S&P 500 earned exactly 0%, did nothing. And all people said was, “Oh, America can’t grow as quick as these other countries. And this is crazy to own just the U.S. I should have most of my money overseas.” Well, from 2010 to 2020, it’s just like a lever was pulled and international stocks and emerging market stocks greatly lagged U.S. stocks for an entire decade. And then it carried over a little bit into this decade. Normally there’s a rotation. International, U.S., it’s unpredictable, moves up and down, but it tends to be one year, three year, five year.
We had a decade of the U.S. outperforming, and then we had a decade of international outperforming. At the turn of that decade, you saw Goldman Sachs, JP Morgan, Vanguard, BlackRock, they all came out and said, “Hey, we think international emerging markets are going to outperform the U.S. over the next decade.” And of course, in the first year of the decade, that’s not what happened. But last year to your point, we did see international outperform. We’re seeing it so far this year. It’s very, very early. And you’re seeing a lot of pundits say, “Rotate from the U.S. to international.” I think that the timing of this is completely unpredictable.
If you look at the valuation of international stocks compared to the U.S. and said, “Well, where does the buyer get more bang for their buck? It is one a hundred percent certainty overseas, there’s higher dividend yield. We get paid more for owning those stocks. The PE ratio is lower. We’re paying a smaller multiple to own those stocks, but just because of those things does not mean those stocks are going to outperform. So that value really is tempting some people to sell all our U.S. and buy international. I don’t think that makes sense. In general, we like to see international exposure added to a U.S. portfolio. We don’t really like to do 50/50 because the U.S. portfolio in itself, especially if it has a lot of large cap stocks, is global. McDonald’s, Walmart, Nike, these are global companies. But I like to have significant exposure overseas. And that means a hundred percent of the time you’re going to outperform one of the markets. And a hundred percent of the time you’re going to underperform one of the markets whether you’re using the global index or the U.S. index.
But I think having those eggs across those two baskets, if you fast forward over the course of your investing life, you’re going to wind up in about the same place but with less volatility because they behave differently. And the cost, the price of doing that, that exposure in the U.S. and overseas is you’re always outperforming one, which is how an optimistic would look at it. Or you’re always underperforming one, which is how most people usually look at it.
Jonathan: Let’s just sort of tie this back into our earlier conversation, Peter, about the mix of stocks and bonds and how you want to take risk on the stock side of your portfolio. One of the reasons I have such a heavy allocation to foreign stocks (in fact, I have a portfolio that looks like the global markets with similar weightings) is because if I’m going to take the risk of investing in the stock market, I want to feel that there’s a very good chance that I will be rewarded for doing so. And the way you ensure you get rewarded for investing in the stock market is by diversifying broadly. And that means not just owning 4,000 or 5,000 U.S. stocks, it means owning a global market portfolio. That’s why I own the global market portfolio. It gives me the confidence to have very few bonds in my portfolio and have this hefty allocation to stocks.
So Peter, it’s time for our financial wellness tip of the month. This month we’re going to be talking about charitable giving. What have you got for me, Peter, on that one?
Peter: For charitable giving, I like really trying to time your giving. Take whatever charities you’re going to support this year, next year, the following year. I’m not asking anybody to make it more or less just whatever you were going to do. And then visit with your CPA or your financial advisor and say, “Hey, if I’m going to make these gifts, how can I make these gifts and get the most significant tax break for doing it?” And there are so many different tax lenses to look at this through. For example, if you’re going to give $10,000 to charity every year for the next five years, instead of writing checks, you might give appreciated stock, and then you’d want to select the right securities. And that way you don’t just get an income tax deduction, you escape a capital gains tax you are inevitably going to have to pay because when the charity sells that stock, they don’t pay capital gains tax.
But also you can accelerate your giving without increasing your giving. If I’m going to give 10,000 a year to my favorite charity, instead, if I’m in a high income bracket this year, maybe I can move the $50,000 into my own foundation this year and get a significant income tax break because it may drive me into a lower income tax bracket. And I’m not giving more, I’m just getting a bigger tax break now. And then from that $50,000 bucket over the next five years, I give away the 10,000 a year. It’s just worth a conversation to say, “Hey, this is what I’m going to do over the next five years. What’s the smartest way to do it?”
Jonathan: And of course, you don’t need your own private charitable foundation. You can set up a donor advised fund — Vanguard, Schwab, Fidelity, they all have programs where you can essentially create your own foundation, fund it in a single year, bunch the contributions so that you get a good tax break in this particular year and then contribute it to the charities over time.
Peter: That’s right. And we’ve set up thousands of donor advised funds for our clients. It’s a very common tool. And if you’re a Creative Planning client and you wanted to look at this, just talk to your advisor about it, we can take care of the analysis as well as setting up that fund.
Jonathan: As you think about charitable contributions, one of the problems under the current tax code is that the standard deduction is so high that unless you are bunching your contributions, it’s very hard to get that tax break for your generosity. But it’s a different situation if you’re age 70 and a half or older because once you’re age 70 and a half or older, you can do something called a qualified charitable distribution from your IRA. And what that means is if you contribute directly from your IRA to a charity, that money that you’re pulling out of your IRA escapes all taxes, even if you usually take the standard deduction. For somebody who is in their seventies or older and they’re charitably inclined, seriously, look at those qualified charitable distributions. It’s a great way to support your favorite charities and avoid taxes on the money that’s coming out of your IRA. So that’s it for us for this month. Peter, it’s been great talking to you. This is Jonathan Clements, Director of Financial Education for Creative Planning. I’ve been talking to Peter Mallouk, President of the firm, and we are Down the Middle.
Disclosure: This show is designed to be informational in nature and does not constitute investment advice. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy, including those discussed on this show, will be profitable or equal any historical performance levels.
