When I see people touting the 60/40 portfolio, I kind of feel like Haley Joel Osment’s character in the Sixth sense. But instead of seeing dead people, I see dead ideas.

You probably know what I’m talking about: a portfolio that tries to automatically balance risk by holding 60% in stocks and 40% in bonds.

This sounds reasonable, but experience shows that people who invest according to this rule leave a lot of money lying around for a long time:

A 60/40 portfolio pays too high a price for low volatility

A quick look at the US stocks, which are shown in purple above by the Vanguard Total Stock Market ETF (VTI), and bonds, in orange by the Vanguard Total Bond Market ETF (BND), over the last decade reveals a problem. One of these funds is sleeping while it works.

The problem is bonds, which have yielded an annualized return of about 2.6 percent over the long term, and U.S. stocks, which have yielded an annualized return of 8.5 percent over the long term.

Source: CEF Insider

First, this should not shock anyone. Bonds are allegedly to produce lower returns over the long term – after all, you invest in them to generate income, and income is very valuable to many investors, hence the overall lower long-term return. The inherently higher risk of U.S. stocks, meanwhile, leads to higher returns.

The math is simple: if we invest $1 million in U.S. stocks and wait a decade, we would have a fortune of $5.1 million based on the historical returns mentioned above. That’s much more than the $670,000 gain we would make if we invested that money in bonds. A broad bond portfolio will naturally reduce our gains, and that’s why this happens.

The 60/40 portfolio produced a profit, but it was a whopping $1,770,000 lower than that of the pure stock portfolio!

By being heavily weighted toward bonds, we literally left nearly $2 million on the table in a decade; the longer you stay in the 60/40 portfolio, the more money you miss out on.

The liquid alternative

The problem with stocks is: what if you can’t wait ten years? What if you need income now? There’s a simple solution: closed-end funds (CEFs).

While the 60/40 portfolio is the old idea – it has been around for more than 50 years – of how to generate income (while sacrificing total return), CEFs are a much better Idea: Turn capital gains into a reliable source of income.

Take, for example, the 7.4% yielding Royce Small Cap Trust (RVT)an equity CEF that was launched in 1986 and has been generating income since then.

RVT converts stock gains into income

Due to the high returns of the RVT, you receive your profits in the form of dividends, which are paid out monthly by this fund.

RVT is no slouch either. Not only does the fund’s history span nearly four decades, but it’s also one of the larger equity CEFs, managing over a billion dollars in assets for investors who can buy and sell their shares whenever they want.

That’s a clear benefit of investing in RVT, but here’s the thing: I don’t think this is the best CEF on the market right now. There are literally dozens of better ones. But sometimes it’s a good buy, such as when its price suddenly drops sharply below its net asset value (NAV, or the value of the underlying portfolio).

At the moment there is no quite this time: Even though the fund’s discount is 11.7% at the time I write this, it has actually been much cheaper this year:

This “dividend machine” is on offer, but we are waiting for a better offer

This is what RVT does not bad Choose today, but as of this writing, the vast majority of CEFs are trading at a discount, so we have plenty of choice in the bargain bin!

The key takeaway here is that once you take a look into the CEF universe, you’ll not only see opportunities to capture the gains that 60/40 investors miss out on, you’ll also discover how to create a diversified portfolio across all markets, as CEFs come from all sorts of sectors and produce average returns of over 7%.

So let’s throw the 60/40 portfolio in the trash – and focus instead on the higher future returns and gains that CEFs can offer.

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