Here’s why an investment giant wants to turn the 60/40 rule on its ear

You’ve heard of the 60-40 rule. But have you ever thought of flipping it?

For a certain breed of cautious investor, Vanguard suggests a tweak to the time-honored principle of investing. Call it the 40-60 rule.

The 60-40 rule suggests that investors park 60% of their money in stocks and 40% in bonds. The stocks deliver growth, but also volatility. The bonds deliver less growth, and less volatility. In theory, a 60-40 portfolio could provide an ideal balance of risk and reward.

If there’s a knock on the 60-40 rule, it’s that the formula might be too conservative.

The S&P 500 has risen by 216% over the last decade, or about 12% a year, according to The Motley Fool.

“We’ve had an extraordinarily above-average period of stock market returns over the last 10 to 15 years,” said Dan Caplinger, a contributing analyst and financial planning expert at The Motley Fool.

Bonds haven’t fared nearly so well. The Vanguard Total Bond Market Index Fund, for example, has a five-year average return of -0.5%.

Why, then, would an investment giant urge investors to buy more bonds?

Let’s start with a caveat. The 60-40 rule isn’t for everyone. Many commentators have given it up for dead.

Investment experts suggest the 60-40 rule works best for investors who might need to spend some of the money in the next five to 10 years: Someone near retirement, or about to send a kid to college, or saving for a home purchase.

“If you have more of a 5- to 10-year goal, then what you do with your money matters,” said Roger Aliaga-Díaz, global head of portfolio construction at Vanguard.

If that’s you, then here’s why you may want to consider flipping your 60-40 portfolio to a 40-60 portfolio: Vanguard believes U.S. stocks are overpriced.

There’s a formula called the cyclically adjusted price-to-earnings ratio. It measures whether stocks are overvalued or undervalued. As of Dec. 22, the CAPE ratio for the S&P 500 stands at 40.40.

That’s really high. The only time the ratio ranged higher was at the peak of the dot-com bubble, in 1999-2000. That bubble eventually burst.

“By almost any measure you can look at, the equity market is overvalued,” Aliaga-Díaz said.

Today, there’s pervasive talk of an AI bubble, a runup of tech stock prices driven by overexuberance about artificial intelligence.

“Long streaks of outperformance generally end at some point,” Caplinger said.

With overpriced stocks in mind, Vanguard predicts meager returns across much of the market in coming years. Over the next 10 years, Vanguard forecasts annual returns of only 2.3% to 4.3% for growth stocks, the class that includes the Magnificent Seven tech giants. For U.S. stocks overall, Vanguard foresees annual gains of 3.5%-5.5%.

With those low expectations for stocks, the bond market starts looking a lot better. Vanguard projects returns of 3.8% to 4.8% for U.S. bonds, with higher forecasts for foreign bonds.

If you flip a 60-40 portfolio to 40-60, the argument goes, you can get the same earnings with less volatility.

“Over the next five to 10 years, we think the 40-60 gets the same return as the 60-40,” Aliaga-Díaz said. “But with half the risk.”

Here’s a rough breakdown of the full 40-60 portfolio, laid out in a December report:

• 36% U.S. bonds

• 24% international bonds

• 15% U.S. value stocks

• 14% international stocks

• 6% U.S. growth stocks

• 5% U.S. small cap stocks

In addition to favoring bonds, that mix of assets stresses several categories of stocks that Vanguard sees as promising in coming years:

• Value stocks. A value stock is a good deal, basically, trading at a relatively low price relative to corporate sales, earnings and dividends. Vanguard expects value stocks to rise by 5.8% to 7.8% a year over the next decade.

• Small-cap stocks. One way to skirt AI stocks is to invest in smaller companies. Vanguard predicts small-cap stocks will rise 5.1% to 7.1% annually over the next 10 years.

• Non-U.S. stocks. Vanguard believes foreign stocks will outperform domestic ones over the next decade, with an average return of 4.9% to 6.9%.

The unusual mix of assets “is all coming from the same place: the overvaluation of the Magnificent Seven,” Aliaga-Díaz said.

Many investors, of course, will balk at the notion of tying up more than half their assets in bonds.

Bonds haven’t fared particularly well in recent years, while stocks have been on a tear. Quite a few investors nowadays forgo bonds altogether.

“Even though Vanguard and others might think we’re in for a period of lower average annual returns for the stock market, history has shown that growth in your portfolio really comes from owning the growth portion of the market, and that is stocks,” said Caleb Silver, editor in chief of Investopedia, the financial journalism site.

But Vanguard’s 40-60 principle is meant to be more of a concept than a hard rule. You could apply it to a range of portfolios, including more aggressive ones.

“If you’re starting with 80-20,” Aliaga-Díaz said, “maybe you can go 70-30.”

This article originally appeared on USA TODAY: Vanguard wants to flip the 60/40 rule: Presenting the 40/60 portfolio.