It allows investors to benefit from the stock market’s long-term capital appreciation, while smoothing out some of the volatile market fluctuations and with low-risk government bonds.
The idea is that equities and fixed income usually don’t move in tandem, therefore when stocks perform poorly, bonds may offset some of the losses and provide income.
Why is the 60/40 portfolio a classic allocation?
To understand why the balanced 60/40 mix has been an investment mainstay for decades, let’s compare its returns with two extremes — a 100% stocks portfolio and a 100% bonds portfolio — from 1926 to 2021.
The historical average annual return for the all-stocks portfolio during that period was 12.3%, with its worst year (1931) returning -43%, based on calculations by Vanguard. The all-bonds portfolio posted an average annual return of 6.3%, and its worst performance (1969) was -8%.
For the 60/40 portfolio, the average annual return came in at 9.9%, with its worst year (1931) returning -26.6%.
This shows that the 60/40 portfolio has offered solid returns and lower levels of volatility. For the moderate-risk investor with a mid to long-term investment horizon, it presents the most optimal risk-reward profile.
Why was it debated recently?
To be clear, the classic allocation model has taken a hit in the last few years.
For one thing, at the height of the Covid-19 crisis in 2020, the high valuations of equities coupled with the low interest-rate environment diminished the appeal of the 60/40 portfolio.
Governments around the world had slashed interest rates to cushion some of the pandemic’s shock to the economies. As a result, the returns on existing government bonds became limited or non-existent. On the other hand, the massive government stimulus, especially in the US, buoyed stock markets, with equities starting their climb in March 2020 and reaching all-time highs by late 2021.
Given those conditions, it was not surprising for the average investor to be tempted to ditch the 60/40 allocation then. Some sought out growth opportunities in equities or alternative assets such as real estate, while cutting their exposure to bonds.
The classic 60/40 mix also saw further stress in 2022. Stubbornly high inflation and rising interest rates caused turbulence and uncertainty across most asset classes. That also disrupted the traditional relationship between stocks and government bonds. Both asset classes were moving in the same direction – downwards – in 2022. The combination of falling equity and bond prices unsurprisingly led to losses in 60/40 portfolios.
Why a balanced 60/40 portfolio will endure
That being said, just because the market dynamics may not be favourable for the 60/40 strategy, it doesn’t mean we should throw the entire strategy out the window.
Despite the headwinds in 2022, the 60/40 portfolio remains relevant and still has value for investors, given its long-term durability and benefits of risk reduction. An analysis by US mutual fund company Northwestern Mutual found that out of all the rolling five-year periods from 1976 till today, only one 60/40 investor cohort suffered negative returns; this was the cohort that bought in 2004 and sold in 2009. All the other cohorts reaped positive returns.
A podcast by Morgan Stanley in August 2022 also noted that even if stocks and bonds had become positively correlated, that correlation was still well below 1 to 1. "That means there are still plenty of days where they don't move together, and this can matter significantly for how a portfolio behaves, and how diversification is delivered, over time," said Andrew Sheets, chief cross asset strategist for Morgan Stanley.
He also pointed out that the 60/40 portfolio remains beneficial in reducing volatility. Despite it being one of the worst declines for bond prices in the last 40 years, the trailing one-year volatility of the US aggregate bond index was still just about 6% — one-third the volatility of US stocks over the same period.
Similarly, Eastspring Investments noted that over the long term, the balanced portfolio is likely to outperform a market timing strategy that tries to switch between equities and bonds.
Investors may wish to continue following the 60/40 approach, but with some tweaks to better ensure long-term growth.
For example, one option is to make each of the stock and bond categories more diversified — be it in developed markets versus emerging markets, large-cap stocks versus small-cap stocks, or investment-grade bonds versus high-yield bonds – while keeping to the overall 60% and 40% allocation.
Some investors may also want to tilt the fixed-income portion of the portfolio towards inflation-protected securities or floating-rate debt instruments to hedge against inflation.
In the current decade, investors should prepare for greater market volatility and get used to a lower-return environment, including from a diversified portfolio of stocks and bonds.
At the end of the day, your financial goals, investment time horizon, risk appetite, and size of capital should go into determining your strategic asset allocation.
The 60/40 portfolio often hits the sweet spot in terms of balancing diversification, growth, and risk mitigation for long-term investors. That is why it remains a hard benchmark to beat and can stand the test of time to outlast its naysayers.
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Next on the Endowus Fin.Lit Academy
Read the next article in the curriculum: What is a core-satellite investment strategy?
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