What's up guys and welcome back to wall street millennial on this channel, we cover everything related to stocks and investing in today's video we're going to take a look at one of the age-old pieces of advice that every investor has heard at some point: holding a diversified Portfolio of 60 stocks and 40 bonds is widely advised for everything from retirement accounts to university endowments, but why is it so loved by investors and does it actually work? That's what we'll be examining in detail in this video before we move further, please note that we are not financial advisors and this video is for entertainment purposes, only make sure you consult with a professional and do your own research before making any investment decision. First, let's go over what exactly the 60 40 portfolio entails. It does not just mean buying 60 dollars of stocks and 40 dollars of bonds for every 100 that you invest. In addition to that, it is essential that an investor rebalances the portfolio from time to time to make sure that the 60 40 ratio is always maintained.

Otherwise, there's nothing special about the strategy. Ideally, the ratio would be rebalanced as frequently as possible within reason, monthly quarterly or at least twice a year. This means an investor must look at the drift in the ratio of their stocks versus bonds since the last rebalancing, if the stock market did better than the bond market since the last rebalancing, then the investor should sell some stocks and buy some bonds until the ratio Is back to 60 40.? Likewise, if the bond market did better than the stock market and as a result, the investor's portfolio has more than 40 bonds and less than 60 stocks, then the investor should sell some bonds and buy some stocks at the end of every rebalancing. The bottom line is that there should be an almost exact 60 40 ratio, the more frequently the investor rebalances and thus the more closely the portfolio follows: the 60 40 ratio at all times the better before taking into account transaction costs and tax consequences.

However, for now we will not consider these extra expenses and assume that the investor rebalances their portfolio every day with no extra cost above the cost to buy these securities to see the value in the continuously rebalanced. 60. 40 split. Let's consider a few market scenarios over the course of your lifetime.

Chances are that you will experience several severe and or protracted market crashes similar to the ones that happened in 2008, 2000, 1987 or others. One such crash can ruin a stock portfolio, especially if an investor panics during the crash and sells at the bottom. The 60 40 portfolio is useful in these crashes and, to a lesser extent, in smaller market sell-offs too, and protecting an investor from losing money with the rest of the markets. The reason is the negative correlation generally observed between stocks and bonds.

It isn't a perfect relationship, but generally when stocks go down sharply, bonds are likely to go up at the same time. This is not a coincidence. Bonds are inherently less risky investments than stocks. They generally pay coupons that set dates and for set amounts, whereas the stock's dividends are subject to being reduced by the company or eliminated entirely at the discretion of management.

Moreover, if your bonds are issued by the us government, then the risk of the government deciding not to pay you your yield, it's probably exceedingly low, whereas if you own stocks, the company behind the stock might go bankrupt and have to stop paying dividends, and if your Bonds are corporate bonds in the event that the company does go bankrupt. The bondholders are first to be paid back, their invested amount by the bankruptcy courts, whereas by the time the courts get to the stockholders, there might not be any assets left in the company to return to investors. So when there is a market crash and investors think that bankruptcy risk among stocks is higher stocks, become less appealing, investors sell stocks and buy bonds instead as a sort of safety asset. That is the reason why, in most stock market crashes in history, we've seen bonds go up at the same time as stocks going down.

But what does that mean for our 60 40 portfolio? It means that if there is a recession and the stock market crashes, then only 60 of the portfolio is exposed to that decline. The other 40 in bonds actually will likely increase in value. At the same time, once this happens, the prudent and disciplined investor will rebalance the portfolio since stocks decrease in value following the crash and bonds increased in value. That means that the investor will have to sell some bonds and buy some stocks, but that is the perfect outcome, because stocks are cheaper to buy at that time because of the sell-off and the bonds will be sold at a higher price than normal once the stock Market recovers and stocks go up.

The investor can then sell those stocks that they bought and buy back the bonds at a lower price. So by maintaining the 60 40 split through consistent rebalancing, the investor automatically always buys low and sells high. This principle of the 60 40 portfolio, allowing the investor to automatically buy low and sell high, is the heart of the magic behind the 60 40 portfolio. It's not just that.

You have some bonds to average out the returns of your stocks. It's the fact that the bonds and stocks are negatively correlated as well. The result is that when one goes down, the other will provide you with extra returns, which you can use at the same time to invest in the other at discounted prices. That being said, there are plenty of criticisms of the 60 40 portfolio, because bonds have so much lower returns than stocks over long periods of time.

When there aren't many severe market crashes, an all stock portfolio does significantly better than the 60 40 portfolio to see just how much money the 60 40 portfolio can leave on the table compared to stocks. Let's consider another scenario: over the past 10 years, the stock market has done extremely well. Besides, the sharp drop in march of 2020, due to the coronavirus pandemic, there have been few drops in the stock market to speak of the s. P 500 rose during this time.

From about 1100 points to 4 300 points as of july 2021, that's a nearly 300 return over 10 years. During this time, portfolios that have a heavy weighting towards stocks have done well. Bond portfolios have done significantly worse during the period the tlt exchange traded fund, which tracks a basket of long-term us. Treasury bonds has increased by a little over one hundred percent during the same time.

That's not as much as stocks by a factor of three overall, the 60 40 portfolio performed slightly better than 200, which is a little more than halfway between the returns of stocks and bonds during that period. But such a large difference between the overall returns compared to stocks leaves many investors, including the billionaire warren buffett, favoring, a more heavily stock-weighted investing strategy according to buffett over a long enough period of time. You won't have to worry about u.s stocks doing poorly, because they've always recovered even after the deepest recessions. So in his mind, you might as well position yourself for higher returns of stocks and buckle up for a long ride, but there might be a way to use the principle of rebalancing negatively correlated assets in the same way as a 60 40 portfolio.

Without giving up all the returns of stocks, billionaire hedge fund manager, ray dalio, has been using his more advanced version of the 60 40 portfolio for many years now with great success. He calls it the risk parity strategy and implements his version in what he called the all-weather portfolio. If you are interested in this topic, i would encourage you to look up ray's phenomenal linkedin articles explaining risk parity in this video, we'll just be doing a basic overview of the topic. Risk parity in his words, means allocating capital to different asset classes based on the risk and return profiles of the asset classes themselves.

That means taking the split between bonds and stocks such that the risk and return of those two types of investments is roughly equal. That necessitates a major change from the traditional 60 40 portfolio, because bonds are much less risky than stocks and also have much lower returns than sox. You need a way to bring both the risk and return up to about the same level of stocks. The way to do that is through leverage leverage is any means of magnifying the returns, both positive and negative of any investment.

The most simple way is to borrow money and use that borrowed money to buy an asset in the case of risk parity. That means borrowing money to buy bonds that increases the expected return of bonds, because the cost to borrow one dollar is usually less than the return that one dollar worth of bonds will return. It also increases the risk of the investment, because, if bonds go down, one percent, the bonds that you bought with borrowed money will cause inflated losses for your portfolio. If you use just the right amount of leverage, then you can bring both the expected return of your bonds, as well as the general risk level up to about the same level as your stocks.

However, here is where the magic of the 60 40 portfolio comes in. Although the total exposure to stocks and bonds will go up, if you use borrowed money to buy more bonds, which increases the portfolio's expected returns, the risk of the portfolio would not be commensurately higher than the 6040 portfolio. That is because of the negative correlation of stocks and bonds. Although the borrowed money that went into buying bonds increases your losses when the bond market goes down, there is an equal exposure to stocks in the risk parity portfolio, which makes up for those losses in the bonds.

This allows you to buy low and sell high whenever the portfolio is rebalanced just like in the 60 40 portfolio, it makes up for the increased risk associated with using borrowed money to buy bonds. Let's take a look at this more closely suppose that you were able to borrow money to buy bonds in exchange for a two percent annual fee. You use that bar of money to buy bonds, doubling your 40 bond allocation to effectively eighty percent of economic exposure to keep things simple. You invest that money in the tlt long-term treasury bond etf, which tracks long-term government bonds.

You keep your 60 allocation to stocks, such as an s p 500 etf over the past 15 years, which is approximately since the tlt etf existed. The risk parity portfolio would have done exceedingly well, whereas the all stock portfolio and the 6040 portfolio both ended up at about 450 by the end of the 15 years, with the stock portfolio slightly outperforming the 6040 portfolio, the risk parity portfolio ended up above the 600 Mark that's a one-third increase in total, even compared to the stock portfolio. In addition, the risk parity portfolio suffered less severe losses in both 2008 and in the coronavirus stock market selloff of 2020 than even the 6040 portfolio. This shows the power of risk parity by balancing the risk and return of two negatively correlated assets, stocks and bonds.

By using leverage you can achieve lower risk and higher reward than either of the two assets alone. You can also do much better than the traditional 60 40 split, alright guys that wraps it up for this video, if you like, the content, make sure to hit that like button and subscribe for future uploads. If you have any thoughts on risk parity or the 60 40 portfolio, let us know in the comments section below in the meantime. Thank you so much for watching and we'll see in the next video wall street millennial signing out.

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