'The 60/40 portfolio is dead'

David Peartree, BridgeTower Media Newswires

A good rule in life is to question any statement that begins with, “experts say.” Sometimes the “experts” truly are expert in their field, but that doesn’t mean that they are right. Sometimes they are anonymous, which calls into question their reliability. And sometimes they are merely commentators, such as yours truly, which means little more than a person with an opinion and a platform from which to share it. Today, many such experts are questioning the merits and relevancy of the  classic 60/40 portfolio allocation: 60% stocks and 40% bonds. Our defense of this model is not to say that it is necessarily optimal or appropriate for all investors. Our purpose is to shed some light on the enduring wisdom of this fundamental approach to portfolio construction. 

The 60/40 portfolio is a shorthand description for a portfolio that is roughly balanced but with a tilt in favor of stocks. Whether its 55% stocks and 45% bonds or 70% stocks and 30%, it amounts to the same thing — an attempt to balance growth and stability. Stocks have a primary focus: growth. The heavier allocation to stocks offers the potential for higher returns and more growth, but this also means more risk. Bonds have a dual focus: income and stability. The allocation to bonds, particularly high-quality U.S. bonds, offers less growth but is substantial enough to mitigate the risk from stocks while historically offering an acceptable level of income.

The 60/40 portfolio is a model for realizing acceptable risk-adjusted returns, and for decades it has lived up to its promise. Over the last 30 years, a 60/40 portfolio offered an annual return of about 9% versus about 11% for the all-stock S&P 500 index. Those are solid returns on an absolute basis while significantly reducing the risk from an all-stock portfolio. Stocks provided long-term growth through a combination of price appreciation and dividends. Bonds provided decent income and a bonus of price appreciation from a long-term trend of falling interest rates, while still providing exceptional price stability relative to stocks. For many individual and institutional investors, it has been the default portfolio model.

Times change and the financial markets certainly have. Stock market valuations are now at historic highs, which does not bode well for stock returns over the next ten years or so. The expected returns from stocks over the next ten years are below their long-term historical average of about 10% annual and are possibly in the low single digits. This suggests we can expect more volatility from stocks over the next 10 years, possibly with periods of steep decline. 

The problem is that bond valuations, too, are at historic highs. An indication of this are the historically low yields now offered by the broad bond market, currently less than 1.5%. Because bond prices and yields have an inverse relationship, such low yields means that bonds are very expensive. 

To make matters worse, inflation has reared its head. Inflation is the nemesis of bonds because it erodes the value of fixed interest payments. The inflation-adjusted yield for most bonds is currently negative. The implication of low rates and persistent inflation is that the returns from bonds are likely to be disappointing for the foreseeable future. 

Against this market backdrop, many “experts” are questioning the continued relevancy and viability of the classic 60/40 portfolio. “The 60/40 portfolio is dead” (Barrons). “Traditional 60/40 portfolio has actually reached its expiration date” (CNBC). “Why the 60/40 approach to investing is dead” (CNN).

Remember, though, that bonds have a dual role in a portfolio: income and stability. Current market conditions, for which the Federal Reserve bears substantial responsibility, have stymied the ability of bonds to produce any meaningful income. But the evidence suggests that bonds, specifically investment grade U.S. bonds, can continue to act as a ballast in a portfolio when the stock market is in decline. 

In the fourth quarter of 2018 when the U.S. stock market was down by over 14%, U.S. investment grade bond prices were up by about 1.6%. During the first quarter of 2020 when the U.S. stock market was done by over 20%, U.S. investment grade bond prices were up by over 3%. The benefits of bonds may be less obvious when the stock market declines are more modest but, clearly, high quality bonds still have a role to play in a portfolio.

And there is always the possibility that income from bonds will be better than expected. Those who fret about the impact of rising rates on bond prices ignore the upside of rising rates: more interest income. Rather than fret, most investors should want interest rates to rise. So long as an investor’s time horizon is longer than duration of their bond portfolio, rising rates should be a net benefit to the investor. Duration is a measure of a bond fund’s sensitivity to rising interest rates and, these days, a typical investment grade, intermediate maturity bond fund has a duration of about 6. Investors whose time horizon is greater than six years will benefit from rising rates in the long run. 

The 60/40 portfolio model is challenged under current market conditions, no question, but it is far from dead. Investors who prioritize the stability that high quality bonds can add to a portfolio will continue to find value in that approach even if total returns are less than historical averages. 

Investors who prioritize income over stability may be tempted to replace or supplement the traditional bond allocation with other asset classes or strategies, but what? That’s a discussion for another time but, in the meantime, here are some important considerations for investors.

The usual starting point in the search for alternatives is to identify other asset classes with a low or negative correlation with stocks. A low correlation means that two different asset classes do not move in tandem under the same market conditions. They may move in the same direction but with different magnitudes of price movement: one is down by a lot, the other is down by only a little. 

A negative correlation is even better because it means that two different asset classes move in opposite directions. Stocks and U.S. high quality bonds are not always negatively correlated but they have demonstrated a strong negative correlation when needed most: when stocks are in sharp decline. This has helped cemented their place in the 60/40 portfolio model. 

Correlation is a useful tool, but it has limitations. One is that the correlation between asset classes changes over time making it hard to rely on current correlation values as predictive of future performance. Second, correlation matters most when stocks are in decline. Even an asset class with a low correlation with stocks over long periods of time may become more highly correlated with stocks during periods of extreme market volatility. Witness the 2008 financial crisis. Virtually all risky assets became highly correlated. High quality U.S. bonds were a notable exception.

There is nothing wrong with exploring alternative asset classes under today’s market conditions, as long as investors do so with appropriate due diligence. Caveat emptor!

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David Peartree JD, CFP is an investment advisor with Brighton Securities Capital Management. This column is a collaborative work by David Peartree and Patricia Foster, Esq. Patricia Foster is a securities law attorney with substantial experience advising members of the financial services industry. The information in this article is provided for educational?purposes and does not constitute legal or investment advice.