The Independent Market Observer

What's the Outlook for the 60/40 Portfolio?

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Dec 21, 2023 10:28:18 AM

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Is it time to start thinking differently about asset allocation, or does the 60/40 portfolio still make sense? That was the question for members of our Investment Management and Research team—and the topic made for some lively discussion.

Watch the video below to hear what the team thinks about this longstanding investment strategy. And if you're looking for a broader economic and market view, click on 2024 Outlook in the sidebar to your right.

Video Transcript

We've been fielding a number of inquiries from our advisors about the notion of the 60/40 portfolio allocation and whether or not it still has merit. So, just curious if anybody has any perspective or just some commentary on the 60/40 allocation, its relevance in today’s world, or should we be thinking differently from an asset allocation perspective?


I think when I look at it, I say, “Okay, what makes that allocation work?” It's that stocks and interest rates go in opposite directions. And that hasn’t been the case, you know, in the past several years, but historically, it has been the case. In a normal world, you would expect it to work again. I think we are in a normal world, so I would expect it to work again. But, maybe I’m wrong.


I would maybe add on to that by saying you need to break apart those two pieces and look at them separately. Where with equities, you get the risk-free rate plus a risk premium, right. And the risk-free rate over the past decade has essentially been zero. Now you have a risk-free rate that's giving you 5 to 5+. So, I would say more so today than in the last decade, the 60/40 absolutely does make sense because there’s 40% of your portfolio that’s actually producing some type of a return, where that wasn’t the case over the last 10 to 12 years. And the risk premium is much narrower at this point because if you expect 7 to 8% return on equities over the risk-free rate, well, that’s only a risk premium of about 3%.


Pete said it far more eloquently, but I’d actually say it’s probably more relevant today than it’s been at any time in the last 15 years. It’s not just they didn’t move together or in opposite directions in 2022, right, but to Pete’s point, you couldn’t get a yield in the fixed income market.


And now you can lock in, theoretically, a 10-year yield at roughly 5%, or at least high 4s, and just clip that coupon for the next 10 years as the base safety aspect of your portfolio.


Tee Sam up, bonds are relevant again.


Yeah, no, it's a great time to be a bond expert. Bonds are back. And I think, you know, kind of taking it back to Brad's point earlier, one of the reasons I think that folks are asking this question so much is the experience of 2022. Right? When both bonds and stocks had pretty strong negative returns throughout the course of the year, which is an aberration. When you look over the long run in history, we typically see pretty negative correlation between those asset classes, right? Normally, when bonds are up, stocks are down, and vice versa. Obviously, last year, given the great reset of interest rates we had, that wasn't necessarily the case. However, looking forward, I do expect that to be the case, you know, bonds are back. But I think almost more importantly, bonds are back to acting like bonds. And that's what we want, you know, in the context of a well-diversified portfolio.


The interesting piece there, too, in 2021, when stocks and bonds were behaving similarly, nobody balked at it because they were both going up. Exactly. When they unwound happened in 2022. Everybody threw up their hands and said, “What's going on here?”, that the 60/40 is broken, so you can’t have it just one way.


Absolutely. And one of the key drivers that we’ve seen when you look over long historical periods is, what drives a negative or positive correlation between bonds and equities over the long run? And one of the major drivers of increased positive correlations are when you see big spikes in inflation. And historically, once those inflationary spikes move through the system, as we’ve started to see, they tend to start to diverge again in terms of absolute performance.


I would add one more thing here, because we’re talking a lot about looking back, and we’re talking about the coupon return. I think from a portfolio planning perspective, we also need to consider what the capital gains or losses are going to contribute. So, now that we have rates at some place where they can actually go down a bit, we have the potential for capital gains in bonds. And if the economy goes down, and if the Fed cuts rates, and stocks get hit, all of a sudden, you’ve got the dual engine here of the coupons, which are reasonable on their own, plus the potential for capital appreciation. We didn’t have that when rates were as low as they’ve been. So, all of a sudden, again, all of the pieces are in place.


Since we all agree, it seems like the question to ask is, “If it’s not relevant anymore, what is, right?” Because there’s no clear-cut answer. Is it a reaction to 2022 that 70/30 or 80/20 is relevant? Or we’ve all seen a lot more questions about how do you use alternatives as a fixed income substitute? Again, probably in reaction to 2022, not the yield. But there’s no clear-cut answer to what replaces the 60/40 in people’s minds.


I think there’s a tendency to look at alternatives as a, you know, a hedge, diversification against equities. But I think what you often find with a lot of alternative allocations is a high correlation to equities. So, you maybe think you’re diversifying your exposure, but you may actually be adding to it with certain alternative asset classes. So, you really want to be thoughtful when you’re making an allocation—it’s not, you know, one size fit all; you have to really be mindful of your underlying exposures and how much correlation you have to risk assets.


I think the other question here is when people say, “The 60/40 portfolio is dead,” what do they mean? Do they mean stocks are dead? Well, they never mean that. So, there’s only two components. So, they must mean bonds are dead. And it strikes me as it’s somebody saying, well, stocks have done really well, so we should be all in stocks. And bonds haven’t done well, so we should stay out of bonds. And that’s the exact opposite of what the math and history shows us.


I mean, ultimately, I’m not going to sugarcoat it—the last two years have been painful for most traditional fixed income investors. But as longer-term investors and asset allocators, we really kind of have to look through the noise and look towards, well, what is the purpose of this allocation in the context of a broadly diversified portfolio, right? And over the long run, bonds have historically exhibited characteristics of sort of a ballast in your portfolio and something that you can use to smooth out returns over the long run. And while, frankly, performance was disappointing on an absolute level, especially in 2022, a diversified portfolio still performed a little bit better, right? And I think it’s a situation where we do have to remember from a portfolio context, you know, if the current winds change, if headwinds become tailwinds and tailwinds become headwinds, you’re going to want that ballast in your portfolio.


I was just going to say, interestingly, to take your point of 2022. But extend that back even further. This is one of the worst periods that we've had for fixed income in years and decades at this point. Yet the 5-year returns for fixed income are marginally negative, if you look at the Agg. I think we're down maybe 1.5% or 1%, which is really just a bad afternoon in the equity market.


So, he kind of went where I was going. The damage that was done on investor psychology for fixed income in 2022 is fascinating. The last time before 2022 that equities and bonds went down together was 1969. No one was expecting anything like it. But to Brad’s point, even last year, it wasn’t my equities are down 35%. It was my bonds are down 15 or 20. I need to get out of it. And that’s why you've seen this move to short money markets. That’s where people want to be. So how do we get over that emotional damage to investor psychology to come back to what we all see? Now’s the time.


I would add, though, I mean, again, to take more of a looking-forward perspective. Pete, you wrote an article several years ago, that pointed out that, yeah, you get hit in the short term for capital values, but then you’re reinvesting at higher rates over time, and over a period of years, you can actually come out much closer to even than the immediate result would suggest to you. And actually, you can even come out ahead sometimes if the rise in rates is large enough, which we just saw one of the largest rises in rates. So, I mean, from that perspective, I think, looking forward, again, we’ve talked about diversification, we’ve talked about noncorrelation, just in terms of absolute performance, I still think there’s an argument to be made for that component.


Right. And that’s something that especially in a mutual fund or fund context that investors tend to overlook is that you have a constant reinvestment of interest and principal that is being reinvested now at higher and higher yields. So, your yield is increasing, which quickly helps recapture those losses that occurred over the past year. And this rising rate environment that we went through was very sudden, very abrupt. So, which had a significant impact to client NAVs. So, it created that shock and awe situation.


I think one of the bias that we need to fight against is not looking too much at what’s really worked in the last call it 12 to 18 months, and that’s been floating-rate and short duration, right. Floating-rate, in particular, we talk to advisors a lot just about not going too much into what’s worked, and floating-rate has been great as interest rates have gone up. But you know, there are a lot of risks. And to my earlier comments about alternatives, you can really be adding to your equity exposure and your risk asset exposure by, you know, going too much into some of these areas that are a little bit more equity sensitive than I think can be generally appreciated.


Even look back over the past decade, those periods where people were moving wholesale into alternatives on a go-forward basis, generally, it wasn’t the best time to be entering that particular asset class. Which, we use the term alternatives, it’s not a monolith asset class. There’s many different types of exposures. So, it really comes down to what type of alternative you’re looking for, which to your point, be mindful of the factor component, and just not simply allocate to alternatives.


I think that's exactly right. And that's the point I wanted to make, which is, when you think about stocks, when you think about bonds, it’s a lot more complicated than people think. You have, you know, you have different asset classes, you have different maturities. You know, my colleagues and I spend all the time looking at that. And that’s just doing the basic stuff: stocks and bonds. When it comes down to alternatives, it’s even more complicated because the whole point is you’re looking at something that is different from what’s going on, that’s taking advantage of different return streams, different chances to get paid for that. And one of the things that’s most important with that is having the expertise to understand that. Brian, you’re 100%, right; Pete, you're 100%, right. You’ve got to be careful because alternatives covers a multitude of sins, and you’ve got to have people who really understand what the story is.

Certain sections of this commentary contain forward-looking statements as of the date published that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Opinions are subject to change without notice.

This communication should not be construed as investment advice, nor as a solicitation or recommendation to buy or sell any security or investment product.

The risk-free rate is the interest rate an investor can expect to earn on a theoretical investment that carries zero risk. In practice, the risk-free rate is commonly considered to be equal to the interest paid on a 10-year highly rated government Treasury note, generally the safest investment an investor can make. Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest, and, if held to maturity, they offer a fixed rate of return and fixed principal value. U.S. Treasury bills do not eliminate market risk. 

Asset allocation and diversification 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. Investments are subject to risk, including the loss of principal. 

A 60/40 allocation is a hypothetical allocation represented by a blended index of 60% stocks (S&P 500 Index) and 40% bonds (Bloomberg U.S. Aggregate Bond Index), for illustrative purposes only. All indices are unmanaged, and investors cannot invest directly into an index. Unlike investments, indices do not incur management fees, charges, or expenses. No specific investments were used in this example. Actual results will vary. Past performance does not guarantee future results. 

Investing in alternative investments may not be suitable for all investors and involves special risks, such as risk associated with leveraging the investment, utilizing complex financial derivatives, adverse market forces, regulatory and tax code changes, and illiquidity. There is no assurance that the investment objective will be attained. 

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.

Mutual funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the mutual fund, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest. 

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. 

The Bloomberg U.S. Aggregate Bond Index (“The Agg”) covers the U.S. investment-grade fixed-rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.

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Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

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