The revival of the 60/40 rule is a plus for brokers–but not for investors

Some experienced brokers (now more often referred to as investment advisors) are pleased at the recent rise in interest rates and inflation. After all, it could lead to a revival of the 60/40 rule, which was in common use for much of the second half of the 20th century, especially among experienced stockbrokers. Veteran brokers understood how to use it to spur clients to do more trading between stocks and bonds, and pay more brokerage commissions and fees.

The 60/40 rule is based on the proposition that a good-quality, balanced portfolio is made up of 60% good-quality stocks and 40% good-quality bonds. This idea leads to another: that investors can enhance their results by “rebalancing” their portfolios when they get away from that 60/40 goal, due to divergences between the bond and stock markets.

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This is one of those clever ideas that at first glance, seems to make sense to many investors. It makes sense to brokers because it’s sure to make money for them. The payoff is rather less certain for the paying customers—the investors.

The problem is that stock and bond prices rise and fall under the influence of ever-changing sets of random factors—sometimes moving them in the same direction, other times moving them apart. These sets of random factors will vary in a random fashion as well. The stock/bond balance in a portfolio can hold steady for long periods, or swing abruptly from the “ideal” 60/40 split in a single day. This can happen even on a quiet day with few news developments to promote buying or selling.

The 60/40 rule gives the broker a rationale for proposing trades in a portfolio when changes in stock and bond prices have moved the portfolio away from the idealized 60/40 split.

This leads to another of the many conflicts of interest that exist in the investment business. However, unlike the hidden bond commissions I mentioned above, some brokers made a living out of the 60/40 rule. In my days as a broker, some old-timers in the office told me they could use the rule to add 2% to 4% of a client’s total portfolio to their gross annual commissions.

Any trade in your portfolio will cost you money in the form of fees and/or commissions, regardless of whether you make or lose money. But every trade you do in your portfolio will make money for the brokerage firm and/or salesperson, of course. That’s how they get paid.

Useless as a market indicator, great as a marketing device

We’ve often pointed out that market indicators sound a lot better than they perform. The 60/40 rule falls a step or two below an indicator. Rather than telling investors how they can make money in their investments, as market indicators supposedly do, this rule tells brokers and financial advisors how they can encourage their clients to do more buying and selling in the market, and thus increase broker incomes.

After all, the rule is based on a belief about the supposed advantage of a particular ratio of stocks to bonds in a portfolio. It’s not as if the rule comes with instructions on when to buy or sell, as you can derive from many market indicators. Instead, it gives brokers a rationale for advising their clients to buy bonds and sell stocks (or vice versa) more often.

Every purchase, like every sale, will pay off for the broker and the firm. It will also cost the client money. Some of these transactions will pay off for the client as well, of course. Others will lead to reduced gains if not losses.

If the 60/40 rule makes a comeback due to the rise in interest rates, changes in the rule are likely to favour the brokerage community. For instance, the new rules will allow a wider range of “equity-like” substitutes for bonds. Some of these substitutes are updated versions of exchange traded funds, or ETFs.

Here are three rules you can follow instead for maximum portfolio success:

Rule #1: Invest mainly in well-established, profitable, dividend-paying stocks.

Our first rule will help you stay out of high-risk, low-quality investments. These investments are always available, in good and bad markets. They come with hidden risks due to conflicts of interest and other negatives. Every year, they lead many inexperienced investors to substantial losses.

This year’s crop of standout losers included bitcoin and other cryptocurrencies; a disappointing crop of new issues (IPOs), which tend to come to market when it’s a good time for the new-issue company or its insiders to sell, but not a good time for you to buy; and slapped-together promotional stocks that hit the market thanks to the SPAC phenomenon, which offers a short cut to IPO status.

Rule#2: Spread your money out across most if not all of the five main economic sectors.

This is our key to successful diversification. The widely disparaged resource sector turned out to have some winners in 2022, in Canadian oil and gas stocks. Nutrien Ltd., our top fertilizer recommendation, shot up that year as the Russian invaders began setting up their planned invasion of Ukraine, which put a big dent in world grain supplies.

On the other hand, if you had disregarded resource stocks with the intention of doubling down on tech stocks, you might have wound up with excessive holdings in tech stocks just as they entered a plunge.

Rule #3: Downplay or avoid stocks in the broker/media limelight.

We’ve recommended a handful of tech stocks and other broker/media favourites in the past few years, but we as always advised against concentrating on them.

Rather that zero in on broker/media favourites, we prefer to apply our first and second rules. If you build a balanced, diversified portfolio of high-quality stocks, it’s hard to go too far wrong.

Do you follow the 60/40 rule? Do you think there is a resurgence?