U.S. economist Peter Bernstein regarded the 60/40 portfolio to be the "center of gravity" between risk and return...

We're talking about a 60% allocation to stocks and 40% allocation to bonds.

The idea behind the 60/40 portfolio was simple... Stocks would provide investors with capital appreciation, while bonds would offer both income and a hedge against "black swan" events – like a pandemic, for example.

In Bernstein's day, a 40% bond portfolio did generally provide folks with real diversification (and real income). When stocks swooned, bonds typically rose... and vice versa.

But as the pandemic took hold last February and March, the 60/40 portfolio failed miserably...

Investors expecting their bond holdings to rise were in for a rude awakening. Morningstar reports that core bond strategies actually lost 3% on average during this span.

Now, that doesn't sound bad compared with 30% losses (or worse) in stocks. But the 3% "average" loss also masked incredible volatility – something you don't expect with bonds. For instance, the Vanguard Total Bond Market Fund (BND) was down an astounding 13.5% at one point last March.

Investors are now rethinking the conventional "60/40" investment portfolio. And it's time for you to consider a new game plan, too...

Rick Rieder, chief investment officer of BlackRock's $2.4 trillion global fixed-income group and co-manager of the BlackRock Strategic Income Opportunities Portfolio (BASIX), knows that investors can no longer trust the traditional approach. As he recently told Barron's...

If you are holding the same portfolio as two years ago and expect it to do the same, it won't. You have to restructure how you think about asset allocation, especially fixed income.

Ben Inker, head of asset allocation for prominent money manager GMO, concurs. In the firm's second-quarter letter to its clients last year, Inker noted that...

All portfolios that include government bonds have both lower expected returns and higher risk than anyone had a right to expect them to have previously.

So with the old playbook becoming obsolete, what should investors do now?

Back in October, living legend Howard Marks published a valuable essay called "Coming Into Focus." In it, Marks reasoned that the Federal Reserve's insistence on keeping interest rates near zero for the foreseeable future leaves investors like us with five less-than-ideal options...

1. Invest as you always have (meaning 40% in bonds) and settle for today's low returns

2. Reduce risk in the face of today's uncertainty and accept even-lower returns

3. Go to cash at a near-zero return and wait for a better environment

4. Increase risk in pursuit of higher returns

5. Put more into special niches and special investment managers

For most investors, settling for lower returns or going entirely to cash – when the Fed has made it abundantly clear that near-zero rates will be the norm for years – simply makes no sense. That means the fourth and fifth items on the list are your only real options today.

In other words, long-term investors need a new portfolio playbook.

My colleague Dan Ferris and I have constructed an ideal replacement for our Extreme Value subscribers. The cornerstone of our strategy is this: You should add exposure to stocks – but only when the risk-reward trade-off is clearly in your favor...

Investors are realizing they must now increase their exposure to stocks in order to pursue higher returns. The problem is, that has driven up stock prices – particularly high-quality, widely held names like Amazon (AMZN) and Microsoft (MSFT).

So to stack the odds of success in your favor, you must insist on buying only when the trade-off between risk and reward is clearly in your favor.

In a recent blog post, New York University finance professor Aswath Damodaran published a graphic that perfectly illustrates how we address this challenge in Extreme Value. Notice "the gap" between a company's intrinsic value and its current share price...

In short, stock prices are driven by investor sentiment. Meanwhile, a company's intrinsic value is a product of future cash flows. Alternatively, you can think of intrinsic value as the highest expected price a knowledgeable buyer would pay for the entire business.

When investors become euphoric, intrinsic value and share price converge. The gap closes, eliminating what we call the "margin of safety."

In other words, the share price starts to resemble the highest sales price that the business would command. And in turn, the stock's potential further upside becomes limited.

The vast majority of stocks today fit into this group, according to our research.

Extreme value occurs when the opposite scenario happens... Pessimism reaches an extreme, causing the gap between intrinsic value and the share price to widen. In turn, the margin of safety expands.

This is when the risk-reward trade-off is most in your favor. That's because the risk of further downside is limited, while the potential upside is much greater.

To see what I mean, let's look at a great business we recommended in April as pandemic-related fear raged...

Constellation Brands (STZ) is an alcoholic-beverage giant. Its holdings include the No. 1 imported beer in the U.S. (Corona), the No. 1 sauvignon blanc in the U.S. (Kim Crawford), and the No. 1 imported vodka in the U.S. (Svedka).

The business has an army of loyal consumers, which helps Constellation earn large profits and consistently produce tons of free cash flow.

But as you know, when the pandemic hit, the ensuing shutdowns across the country crushed the restaurant and bar industry. In turn, investors panicked out of Constellation's stock... It plunged from about $210 per share in February to the low $140s by early April.

More important, as this sell-off played out, the "gap" between Constellation's intrinsic value and share price became so large that you could drive an oversized 16-wheeler through it...

And while consumers were stuck inside due to COVID-19 restrictions, they didn't quit drinking... They simply drank at home. Investors overlooked the fact that roughly 85% of Constellation's business is done "off premise" at places like grocery stores and liquor stores.

In short, the pandemic didn't hurt Constellation nearly as much as investors expected. And the huge gap between its price and intrinsic value at the time allowed us to help our subscribers profit...

Today, Constellation is once again trading for well over $210 per share. And subscribers who followed our advice in early April are up about 55%.

In a world of near-zero rates, you must shift exposure toward stocks and away from bonds... which increases your portfolio risk. So to sleep well at night, you absolutely need to become attuned to the gap between share price and intrinsic value.

And you should insist on only adding new positions where the odds of success are clearly stacked in your favor.

Good investing,

Mike Barrett

Editor's note: More people are starting to realize the bull market won't last forever. But Mike and Dan's Extreme Value readers are in on the perfect stock idea for these times. It's a company that can succeed if the bull market continues, but will likely do even better in a downturn... Learn why Dan believes it could be his most important recommendation ever – with 1,000% upside over the long term – right here.

Finding world-class companies that the market underprices is a great way to generate long-term wealth. And it's exactly what's happening with this under-the-radar stock today...

Market Notes

WHY THIS 'PICKS AND SHOVELS' MODEL IS MAKING BIG GAINS

Today, we're checking in on a company that's in high demand...

As regular readers know, we love investing in "picks and shovels" businesses. These are the companies that provide the tools and services that support broad trends. They'll profit no matter who performs best in the industry... which means less risk for investors. Today's company is a perfect example...

TE Connectivity (TEL) is a $45 billion leader in industrial technology. The company makes products like antennas, sensors, and connectors. It has seen increased demand recently due to two popular markets... electric cars and cloud-based applications. In the first quarter, TE Connectivity reported net sales of $3.5 billion, up 11% year over year. Total orders for its products also jumped 25% year over year to roughly $4 billion.

As you can see in today's chart, TEL shares are up more than 150% from last year's mid-March lows... And they just hit a fresh all-time high. As long as electric-car makers and cloud-based companies turn to TE Connectivity to improve their products, this trend should continue...