The Independent Market Observer

Is the 60/40 Portfolio Dead?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jul 14, 2022 3:52:53 PM

and tagged Commentary

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60/40 portfolio

One of the standard portfolios that investors use, with 60 percent stocks and 40 percent bonds, has had a really bad start to the year, with the largest declines in decades. These portfolios were supposed to balance growth and risk, with both allocations growing over time but with each offsetting the other. When stocks were up, bonds would be down, and vice versa. As such, this was the portfolio that would let investors participate in the market’s gains without too much of the downside.

Then came 2022. When interest rates started to climb, stocks dropped—but that was expected. What was unexpected? Bonds also declined significantly. Instead of one allocation offsetting the other, both dropped for the first time in decades. What was supposed to be safer turned out not to be. And if it isn’t safer, why do it? Maybe the 60/40 portfolio should be dead.

Not So Fast . . .

But maybe not. In fact, the only reason that would make sense is if we expect the sharp rise in interest rates this year to keep happening every year for the next several years. The reason the model broke was the unprecedented spike in rates. If rates don’t keep spiking, then the model works again. What the market is telling us is that rates should not keep spiking.

Let’s look at the interest rate on the 10-year U.S. Treasury note. With inflation at more than 9 percent, it still has stabilized under 3 percent. Clearly, over the next 10 years, markets expect interest rates to stay around current levels, on average. If interest rates don’t spike but instead move up and down with the economy, then we are back in an environment where the 60/40 portfolio can work.

Back to Normal?

The reason is simple. Stocks go up over time, as the economy grows and companies earn more money. But during a recession, they go down as expected earnings decline. During a recession, though, the Fed cuts interest rates and bond prices tend to rise, offsetting the pullback in stocks. As long as the economy and interest rates move within a normal cycle, that relationship allows a 60/40 portfolio to work.

That normal cycle is the key here. What we got with the pandemic and its aftermath was anything but a normal cycle. The Fed cut rates to zero, and Congress dumped money into the economy. The drop in rates made bonds worth more as stocks tanked—but then stocks rebounded strongly even as bonds remained expensive. Now that interest rates are normalizing though, so have valuations, for both stocks and bonds. Rather than a gentle adjustment, we saw a shock and then a reversal. The shock made investing more attractive to investors, but the reversal hurt (a lot). It is this reversal that is making people wonder whether 60/40 is dead.

As noted, things are normalizing. Stock valuations are back to where they were before the pandemic, as are interest rates. Absent another pandemic (and we seem to have all agreed to ignore Covid-19), there is no reason for another shock. With both valuations and rates back to where they were, the 60/40 portfolio should be as applicable now as it was then.

What Are the Risks?

The one real risk factor here is whether we do see another spike in rates. Given the multi-decade highs in inflation and the fact that markets expect the Fed to hike sharply, I would argue that most of the risks are already priced in. Indeed, long-term interest rates support that conclusion. Is there some risk? Perhaps. But it is likely more than offset by opportunities for rates to drop as well.

So, Is the 60/40 Portfolio Dead?

That brings us back to the question at the top of the post. As usual, the headlines are fighting the last war. The time to worry was when rates were cut, not now. Now, rates are high enough that the tradeoff between stocks and bonds can resume—just as the 60/40 portfolio expects.

Bonds are subject to availability and market conditions; some have call features that may affect income. Bond prices and yields are inversely related: when the price goes up, the yield goes down, and vice versa. Market risk is a consideration if sold or redeemed prior to maturity. 

Asset allocation programs do not assure a profit or protect against loss in declining markets. No program can guarantee that any objective or goal will be achieved.


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