“The news of my death is greatly exaggerated.”
For over a decade, commentators have been prophesying the death of the traditional 60/40 portfolio, or at least predicting its imminent demise. Still, the humble 60/40 portfolio, which doesn’t seem to take these projections into account, has continued to deliver solid results.
The goal of these commentators is a portfolio of 60% US stocks and 40% US bonds. The portfolio is periodically rebalanced to roughly maintain this asset allocation.
Just the facts
From January 2007 to March 2021, a two-bear market period, the 60/40 portfolio produced an annualized return of 7.97% versus 9.88% for the US equity market.
The maximum drawdown for the 60/40 portfolio over this period was 30.7% versus 50.9% for the US equity market.
Thus, the 60/40 portfolio returned 80% of the US equity market return with a 40% lower maximum drawdown. Obviously the 60/40 portfolio is alive and well.
What about the future? Will it continue to show strong signs of life or will it eventually succumb to deliver the experts who have been in error for so long?
State the case
The case against the 60/40 portfolio is now the same as it has been for most of the last decade. Bond yields are close to historic lows. They are likely to rise and cause investors to lose capital. Even if they stay at the current level, they will not generate sufficient returns. The stock market is highly valued and is likely to generate lower returns in the future.
This case is largely based on predictions of what is “likely” to happen in the future. These predictions have been wrong for the past 10 years. Why should they be better now? Finance theorist and author William Bernstein once said: “Trying to predict returns in the stock markets is just stupid; Trying to predict interest rates is completely idiotic. “
But what if these predictions finally come true? After all, bond yields have long been at all-time lows, and recently there have been upward moves. Share prices have been high for a long time, also due to historical valuation standards. How much higher can you go?
Why the 60/40 portfolio still has life
When bond yields rise, investors suffer capital losses. However, research shows that these losses are often only temporary. Because investors reinvest in bonds with higher nominal yields, they can make up for these losses in a relatively short period of time. In fact, you may be far better off absorbing the capital loss in the short term and owning the higher yielding bonds in the long term.
If bond yields remain low, the bonds in the 60/40 portfolio can play another important role: minimizing volatility. During the January 2007 to March 2021 period mentioned above, the standard deviation of the 60/40 portfolio was 9.49% versus 16.04% for the US stock market. And as we’ve seen, the maximum drawdown of the 60/40 portfolio was far less thanks to its bonds.
The correlation of US stocks to US bonds was roughly zero over this period, which provided a decent diversification advantage. Of course, you could only hold US Treasuries and benefit from their negative correlation to US stocks, but then your bond holdings would be less diversified and the long-term return on the bond portion of your portfolio would likely be less.
Also, remember to value the returns you will get on your bond holdings in real terms, not in nominal terms. In 1980 you could buy a 10-year government bond with a yield of 12.3%. However, individual tax rates could be up to 70% and inflation was around 11.9%. After taxes and inflation, the fat nominal government bond could turn out to be clearly negative in real terms. In today’s environment of lower taxes and lower inflation, bonds that are far less yielding could generate higher real returns.
It is certainly true that stocks are valued highly by traditional standards and may generate lower returns in the future. But if stocks only generate 5 to 6% return, is that so bad?
Compared to what?
It all depends on the alternatives, and this is an important point that is often overlooked in the debate about the vitality of the 60/40 portfolio 10 years.vThere is no way you can know for sure.vBut if you believe that this is true, what should you do about it?
Many of the 60/40 portfolio doomsday sayers have a not-so-hidden motive for predicting their doom. You have something to sell. It can be a tactical strategy or an alternative strategy. This can be raw materials, managed futures or real estate. Of course, these products always have a compelling story. But on closer inspection, these stories are often flawed.
Certainly, adding asset classes with the right performance traits can theoretically improve the traditional 60% US stocks / 40% US bonds portfolio. International stocks and bonds are examples of investments that can further diversify the portfolio without adding unjustified risks or costs. However, additions should only be made if, after weighing the potential performance benefits, risks and costs, there is a compelling reason.
It is entirely possible that the returns on the traditional 60/40 portfolio will be lower in the next 10 years than in the last 10 years. But we should be careful before declaring the death of a portfolio that has been so robust for decades and has produced such strong results. Tinkering with the portfolio to increase returns could easily have the opposite effect, introducing unintended risk and increasing costs at the same time.
Scott MacKillop is CEO of First Ascent Asset Management, the first TAMP to provide Flat-rate investment management services for financial advisors and their clients. He is an ambassador for the Institute for the Fiduciary Standard and a 45 year veteran of the financial services industry. He can be reached at [email protected]