Hidden Costs of Common Investment Strategies

If you are currently working with a wealth manager, here’s a crucial piece of advice: give strong consideration to moving on (or managing your investments independently) if they suggest adhering to the traditional “60/40” investment strategy.

This rule recommends that individuals allocate 60% of their portfolio to stocks and 40% to government bonds as a retirement strategy.

Later in this discussion, we will highlight a particular fund that would have been overlooked had we rigidly followed the 60/40 strategy or partnered with a wealth manager who did. Fortunately, this fund continues to be available, offering a robust 5.5% dividend with potential growth.

The Unusual History of the 60/40 Investment Rule

While we won’t delve too deeply into economic theory, the origin of the 60/40 rule is quite fascinating and warrants a brief exploration.

This investment guideline emerged in the 1950s when a group of financial advisors sought to incorporate the groundbreaking research of Nobel Prize winner Harry Markowitz, who pioneered Modern Portfolio Theory (MPT), a vital concept in diversification.

Proponents of the 60/40 strategy often claim it is rooted in MPT, but this is misleading. In reality, Markowitz initiated his own investment with a 50/50 allocation to minimize potential regret, a decision made without rigorous data analysis. He later acknowledged, “I should have computed the historical co-variances of the asset classes and drawn an efficient frontier.” Instead, his decision stemmed from the emotional contemplation of missing out on market gains while being overly cautious.

As such, the 60/40 rule misinterprets a bias that led a distinguished economist to develop a theory, rather than being a conclusive result of that theory itself!

The Flaws of a Rigid Retirement Strategy

Before we critique this method, it’s essential to clarify that we are not advocating for a lack of diversification—quite the opposite! The primary flaw of the 60/40 rule is that it restricts an investor’s ability to allocate a greater portion of their portfolio to the fastest-growing assets available in the market. Furthermore, it neglects to consider individual investor goals and life stages.

Consider this scenario: an investor in 2006 approaches a wealth manager wanting to shift more of her portfolio into technology stocks, recognizing the meteoric rise of the internet and smartphones, yet the wealth manager suggests sticking with the conventional 60/40 strategy. Fast forward nearly two decades, and the stark differences between the 60/40 allocation and the performance of the S&P 500 and NASDAQ become clear.

Following this outdated advice would have resulted in significant missed opportunities. An investor who committed $10,000 annually while adhering to the 60/40 rule missed out on nearly $700,000 compared to the performance of the NASDAQ 100 and roughly $300,000 compared to the S&P 500 over the same period.

It’s important to emphasize that this isn’t an argument for completely ignoring other asset classes outside of stocks; rather, it advocates for a flexible approach that could yield far superior returns than strictly adhering to a “rule” such as 60/40.

Some wealth managers defend the 60/40 strategy by asserting that it reduces volatility. This statement holds some truth—during market downturns like in 2022, the NASDAQ 100 suffered significant losses while the 60/40 portfolio performed better by comparison. However, its decline of 16.1% was nearly aligned with the 18.2% drop in the S&P 500, highlighting that this allocation did not significantly mitigate stock market volatility; it was simply less exposed to the more volatile tech-centric NASDAQ 100.

During more severe downturns, such as the 2008/2009 crisis, the 60/40 portfolio fared better than the S&P 500. However, it significantly lagged behind the performance of the NASDAQ 100.

This outcome is logical when contextualized: during the subprime mortgage crisis, the NASDAQ 100 was still reeling from the burst of the dot-com bubble, limiting its potential for further declines compared to both the S&P 500 and the 60/40 portfolio.

Fast forward to the COVID-19 pandemic, a period one would expect the 60/40 allocation’s volatileness to offer some protective benefits; yet, this expectation fell short.

The NASDAQ 100 quickly rebounded from its initial slump due to the pandemic fueling tech companies like Zoom Video Communications, Amazon, and Uber Technologies.

The essential takeaway here is that adhering strictly to a predetermined rule like “60/40 allocation” can lead to suboptimal outcomes. Being agile and adjusting investments according to market dynamics leads to far greater opportunities for wealth accumulation.

Of course, navigating these decisions can be difficult, especially in emotionally charged market environments.

One effective strategy for managing risk is to invest in a well-diversified and actively managed technology-focused closed-end fund (CEF) that offers a solid dividend, such as the Columbia Seligman Premium Technology Growth Fund, which yields 5.5%. This hefty return not only provides immediate cash flow but also allows for reinvestment, contributing to portfolio growth while reducing overall risk.

The STK fund primarily invests in large-cap technology firms, with top holdings including Microsoft, Apple, and Oracle. Additionally, this fund trades at a 2% discount to its net asset value (NAV), which is significantly below its five-year average of 3.6%. This provides a cushion against potential market downturns while also offering room for growth.

When we consider its performance, the STK has delivered an impressive 17.6% annualized return over the past ten years. To illustrate, if you had invested $1 million a decade ago and reinvested your dividends, that investment would have appreciated to approximately $4.9 million as of now.

This highlights the benefit of actively adjusting your investments in high-quality closed-end funds across varying asset classes in response to market changes. Such an approach not only enables entry at favorable prices (a significant advantage over ETFs) but also allows for higher yields.

Moreover, while the average yield of most closed-end funds hovers around 8%, they also encompass a diverse range of sectors, including real estate investment trusts (REITs), blue-chip stocks, and corporate bonds.

These funds tend to outperform stagnant government bonds, making them a smarter choice than merely dedicating a portion of your portfolio to low-yielding fixed-income assets.