Which is a better investment: buying a home or investing in stocks?
Since 1995, stock prices have outperformed home prices by a factor of four, but which is actually the better investment for building wealth?
You’ve probably heard of the 60-40 rule. But have you ever thought about flipping it?
For a certain type of cautious investor, Vanguard suggests tweaking the time-honored principles of investing. This is called the 40-60 rule.
The 60-40 rule suggests that investors keep 60% of their money in stocks and 40% in bonds. Stocks bring growth, but they also come with volatility. Bonds have less growth and less volatility. In theory, a 60/40 portfolio provides the ideal balance of risk and reward.
The problem with the 60/40 rule is that the formula may be too conservative.
According to The Motley Fool, the S&P 500 index has risen 216% over the past decade, or about 12% annually.
“Over the past 10 to 15 years, we’ve had a period of significantly above-average stock market returns,” said Motley Fool contributing analyst and financial planning expert Dan Caplinger.
Bonds haven’t fared so well. For example, the Vanguard Total Bond Market Index Fund’s five-year average return is -0.5%.
Here’s why you should buy more bonds
So why are investment giants encouraging investors to buy more bonds?
Let’s start with the caveats. The 60/40 rule doesn’t apply to everyone. Many critics have given it up for dead.
Investment experts suggest the 60/40 rule is best suited for investors who need to use some of their money over the next five to 10 years: people nearing retirement, people looking to send their kids to college, or people saving to buy a home.
“If you have a five- to 10-year goal, what you do with your money becomes important,” said Roger Arriaga Diaz, Vanguard’s global head of portfolio construction.
If this is you, you may want to consider switching your 60-40 portfolio to a 40-60 portfolio. Vanguard believes U.S. stocks are overvalued.
Are we in an AI bubble?
There is a formula called the cyclically adjusted price/earnings ratio. Measures whether a stock is overvalued or undervalued. As of December 22, the S&P 500’s CAPE ratio is 40.40.
That’s really high. The only time this ratio was higher was during the peak of the dot-com bubble in 1999-2000. That bubble eventually burst.
“By almost any measure, the stock market is overvalued,” Arriaga-Diaz said.
Today, there’s talk of an AI bubble, a boom in tech stocks caused by excessive enthusiasm for artificial intelligence.
“Long-term outperformance streaks usually end at some point,” Caplinger said.
Vanguard predicts a dark decade for stocks
With overvalued stocks in mind, Vanguard predicts only modest gains for most of the market over the next few years. Over the next 10 years, Vanguard expects growth stocks, including tech giants like the Magnificent Seven, to return only 2.3% to 4.3% annually. For U.S. stocks overall, Vanguard expects them to rise 3.5% to 5.5% a year.
The bond market is starting to do much better because expectations for stocks are low. Vanguard expects returns on U.S. bonds to be between 3.8% and 4.8%, and higher on foreign bonds.
There is an argument that you can flip a 60/40 portfolio to 40/60 and get the same return with less volatility.
“We believe that over the next five to 10 years, 40-60 will have the same returns as 60-40,” Arriaga-Diaz said. “But it’s half the risk.”
Portfolio breakdown for ages 40-60
Here’s a rough breakdown of the overall portfolio for ages 40 to 60 in the December report:
- 36% US bonds
- International bonds 24%
- 15% US value stocks
- 14% Overseas stocks
- 6% US growth stocks
- 5% US small cap stocks
In addition to favoring fixed income, its asset mix highlights several categories of stocks that Vanguard sees as promising in the coming years.
- Value stocks.Value stocks are essentially value stocks that trade at relatively low prices compared to a company’s sales, profits, and dividends. Vanguard expects value stocks to rise 5.8% to 7.8% annually over the next 10 years.
- small cap stocks.One way to avoid AI stocks is to invest in smaller companies. Vanguard expects small-cap stocks to rise between 5.1% and 7.1% annually over the next 10 years.
- Non-U.S. stocks.Vanguard believes foreign stocks will outperform domestic stocks over the next 10 years, with average returns ranging from 4.9% to 6.9%.
Arriaga-Diaz said the unusual mix of assets “all come from the same place: the overvaluation of the Magnificent Seven.”
Investors may be hesitant to buy bonds
Of course, many investors would balk at the idea of locking up more than half of their assets in bonds.
Bonds haven’t been doing particularly well in recent years, while stocks have plummeted. A significant number of investors are now abandoning bonds altogether.
“While Vanguard and others may think we’re entering a period of declining average annual stock market returns, history shows that portfolio growth actually comes from owning the growing part of the market: stocks,” said Caleb Silver, editor-in-chief of financial journalism site Investopedia.
However, Vanguard’s 40/60 principle is intended to be more of a concept than a hard-and-fast rule. It can be applied to a variety of portfolios, including more aggressive portfolios.
“If we start at 80-20, maybe we can get to 70-30,” Arriaga-Diaz said.
