• The 60/40 portfolio has been a benchmark for a balanced portfolio for many decades 

• In 2022 rising bond yields and lower stocks meant it performed very poorly 

• However, The 60/40 portfolio is expected to provide benefits to investors over the coming years

Macroeconomic Commentary 

Introduction 

The long-term benefits of a balanced portfolio have been clear to investors for a long time. One popular benchmark is the 60/40 portfolio, where 60% of the investments are in equities and 40% of the portfolio is in bonds. This combination of asset weightings is often attributed to the work on modern portfolio theory (MPT) by Harry Markowitz, first introduced in a 1952 essay. With a lot of math's, Markowitz established the idea that investors could maximize the expected returns from a portfolio, taking risk into account, by putting different assets into a portfolio that have a correlation of less than one. The idea is that the portfolio’s variance, as a measure of volatility or risk, will be lower than holding just equities, and investors will benefit from this without considerably reducing their expected returns.

Well before Markowitz investors knew that putting money into different asset classes or instruments benefitted risk adjusted returns. In other words, don’t put all your eggs in one basket. But Markowitz and others were able to show this mathematically and provide formulas to quantify the benefits.

Historical returns 

An analysis of historical returns proves the long-term benefits of a 60/40 portfolio. Data from the CS Global Investment Returns Yearbook shows real (inflation adjusted) US equity market long-term annualized returns of 6.4% from 1900 to 2022. Bonds returned far less on average, only 2.0%, but by adding bonds to a portfolio of equities the volatility would have been reduced considerably. The 60/40 US portfolio returned a real annualized 5.0% but with a standard deviation of 13.5% compared with an equity-only standard deviation of 19.9%. Why this works is that often (though not always) the price of bonds rise at the same time equities fall and vice versa. In a bad year for stocks this can reduce the total loss and over time it evens out the returns.

Chart 1: US 60/40 portfolio real return contributions 

This is illustrated in the chart above showing the real return contributions from stocks (blue) and bonds (red) from a US 60/40 portfolio (NYU data). In years where stocks fell (blue bars), bonds often rose in value, reducing the overall loss in the portfolio. However, the chart also shows how bad 2022 was– one of the worst years ever for returns, with both bonds and stocks down substantially. 

Why Bonds and Stocks have a low correlation 

When the economy slows, the outlook for profits dims and so stocks often don’t do very well. But bond prices tend to rise (yields fall) when the economy slows and/or inflation goes down because investors expect the central bank to respond with lower policy interest rates. Bonds are generally thought to offer particularly good protection against recessions. Stocks usually fall in a recession, partly because profits fall but also because, at least at first, there is the possibility that a moderate downturn turns into something worse. Conversely bonds do well (prices rise and yields fall) as investors anticipate lower inflation and lower interest rates from the central bank. 

However, the long-term data mentioned above makes clear that, while a low correlation is typical (and of course beneficial), the 21st century was unusually good for the 60-40 portfolio (until 2022) because on average the correlation was negative (-0.23). In the prior half century it was +0.3 and in the first half of the 20th century it was +0.42. This data is based on averaging across 21 different countries. Across the whole 121-year period the average correlation was 0.2 which is low. Ultimately this is what lies behind the popularity of the 60-40 portfolio. But there is nothing magic about 60-40. Investors willing to take higher risk have often plumped for 70-30 or even 80-20. Those preferring to take less risk have used 50-50 or even 40-60. The key point is to diversify, to take advantage of that low correlation.

Prospects for the 60-40 portfolio 

Many investors were shocked by 2022 results. Not only did bonds fail to offset the sharp fall in stocks but they fell heavily in value too and investors in the 60-40 portfolio suffered one of the worst years ever. But, of course, bond yields were at exceptionally low levels at end 2021– the US 10-year Treasury was yielding only 1.52% on December 31st. This was well below the actual inflation rate and even below the Fed’s target 2% inflation rate. Today yields are much higher, which lowers the risk of another truly bad year in bonds and also leaves room for a big fall in yields (rise in bond prices) if the economy goes into recession. That said, it is important to recognise that the early 21st century, and indeed the whole period from about 1981 to 2021was historically unusual in that bond yields persistently trended downwards as inflation declined. The US 10-year yield was over 15% in 1981 and the continuing decline in yields added to bond returns most years as yields trended down. Moreover, especially in the early years, real bond yields were often unusually high. Today’s bond yields are no longer so extraordinarily low as in 2020-21but they are not exceptionally high either. The bottom line is that after the disaster of 2022, the 60-40 portfolio is back, and makes more sense than it did in 2020-1 when yields were so low. Bonds are once again attractive as investments now that yields are above inflation. But investors would be wise to consider diversifying beyond these asset classes too, into property and other alternatives. They often have low correlations with equities too.

Conclusion 

Looking ahead and there are reasons to believe that the 60/40 portfolio will continue to serve a purpose in investment planning. Individual needs and goals will create different blends of stock, bond, cash and alternative asset holdings within a portfolio. As abroad proxy for a balanced portfolio though, the 60/40 benchmark may continue to deliver returns along the lines of the historical long term real returns. Bond yields are higher than they have been for decades which will give the added benefit of reinvested income to returns.

The information contained within is for educational and informational purposes ONLY. It is not intended, nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional at Falco Private Wealth before making an investment decision. Falco Private Wealth are Authorised and Regulated by the Financial Conduct Authority. Registered in England: 11073543 at Millhouse, 32-38 East Street, Rochford, Essex SS4 1DB.

Contact

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