Death Of The 60/40

Periodically, pundits and active fund managers declare the death of the 60/40 portfolio. Their voices have steadily grown louder lately.

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This has been a challenging year for investors. On top of the equity bear market, the steep losses in bonds have been especially surprising, leading some to question whether the classic 60/40 portfolio is dead.

Before we consider the merits of this statement, what exactly is a 60/40 portfolio and why the “additional” negative press being piled into this strategy, in a year when almost all portfolios are suffering.

60/40 explanation

The 60/40 referred to denotes 60% shares and 40% bonds, being the overall allocation of the average investment portfolio.

That’s it. It’s not a magic formula. It’s just adding up.

It’s no more than a catchy phrase. Say what you see and all that.

Why the fuss right now

Over the long term, equities have a higher expected return than bonds.

The primary role of bonds in an investment portfolio therefore, is to provide a buffer when equity markets fall. This is because historically, bond prices have tended to move in the opposite direction to share prices.

The current perfect storm of negative market drivers* has pushed share and bond prices downwards in lockstep, weakening the inherent diversification protection of a balanced portfolio.

* Market, economic and geopolitical conditions all appear fraught. Inflation is hitting 40-year highs, the US Federal Reserve and other central banks are sharply reversing or looking to reverse monetary policy, the pandemic hasn’t gone away, and supply chain woes have been exacerbated by Covid-19 lockdowns in China and Russia’s invasion of Ukraine, with the latter putting the Western bloc the closest to a war footing in decades.

Brief, simultaneous declines in shares and bonds however are not unusual.

Viewed monthly since early 1995, the nominal total returns of both global shares and investment-grade bonds have been negative around 13% of the time. That’s a month of joint declines a little over every seven months or so, on average.

Historically though, share-bond diversification recovers within a few months.

Source: Vanguard.

Extend the time horizon, and joint declines have struck less frequently. In the period covered, investors never encountered a three-year span of losses in both asset classes (and barely encountered it over a one-year period).

Drawdowns in 60/40 portfolios have occurred more regularly than simultaneous declines in shares and bonds. This is due to the far-higher volatility of shares and their greater weight in that asset mix. One-month total returns were negative just over one-third of the time in the period. The one-year returns of such portfolios were negative about 16% of the time, or once every six to six-and-a-half years, on average.

The key point here is that what we are experiencing in not an anomaly, it just feels worse when we are in the middle of it.

Is It Really Dead?

Although 2022 has seen the one of the worst years in history for many bond indices, the year-to-date experience for a 60/40 portfolio has not even cracked the top (or, alternatively, worst) five historical drawdowns of the last century. Two of these in recent memory, the Dot.com bubble and the Credit Crunch.

A 19% loss of wealth is not all that fun, but it’s only two-thirds of the drawdown investors endured during the latter of these (see below).

It's important, and especially so during difficult market conditions, to focus not solely on where returns have been but also on where they could be going in the months and years ahead.

Looking at the performance of a 60/40 portfolio following a decline of 10% or more since 1926 (see below), we see clearly that returns on average have been strong in the subsequent one, three, and five-year periods.

History makes a strong case for sticking with your longer-term plan and should help serve as a reminder that steep declines shouldn’t derail your progress toward realising the expected benefits of investing.

X to Z Comment

The 60/40 remains a sound benchmark for an investment strategy designed to pursue moderate growth.

But prominent and useful as a benchmark though it is, the 60/40 formula is not somehow unique and magical.

Talk of its demise is ultimately a distraction from the process of investing successfully over the long term.

The broader, more important issue is the effectiveness of a diversified portfolio, balanced across different asset classes – in keeping with your risk tolerance and time horizon.

In that sense, “60/40” is a sort of shorthand for your strategic asset allocation, whatever your actual target mix.

For some with a longer-time horizon, the right strategic asset allocation mix may be more aggressive, say 80/20 or even 90/10. For others, closer to retirement or more conservative-minded, 30/70 may do it.

I prefer to use the terms growth assets and defensive assets as opposed to shares and bonds.

This is because the investment landscape offers access to many more assets classes than straight forward shares and bonds.

Investments that were previously exclusive to professionals and institutions can be added into portfolios relatively easily.

Whatever we call a target asset mix and whatever we include in the portfolio, successful investing over the long term demands perspective and long-term discipline.

Stretches like the 2022 year to date – and some bear markets that have lasted much longer – test our patience.

This isn’t the first time that the 60/40 portfolio and markets in general have faced difficulties – and it won’t be the last. Further economic struggles will lie ahead, and market returns will still be muted from time to time.

But the 60/40 portfolio and its variations are not dead.

If history is any guide, there’s reason to believe the classic 60/40 portfolio is alive and well and could be poised to deliver healthy returns going forward.