One topic under heated discussion is the relevance of the “60/40” portfolio (60% equities and 40% bonds). This article delves deeper into this debate and what it means for investors.
The Theory
The 60/40 approach is a traditional approach to diversification. The investor is exposed to the growth potential of stocks, while being protected by the stability of bonds.
Key to the strategy is the negative correlation between stocks and bonds. When stocks perform poorly, bond prices have typically increased, stabilizing returns.
The 60/40 strategy is simple and has (until recently) been more effective than more complex investing strategies.[1]
But the “death” of the 60/40 portfolio was being announced even in 2009, at the beginning of one of its best-performing decades.[2]
What has changed?
The Change
In 2022, stocks and bonds both declined in value. Bonds failed to offset the decline in equities in 60/40 portfolios.
When the market recovered in 2023, stocks and bonds both rose in value. With the improved performance, many news stories declared the return of the 60/40 portfolio.
But focusing on performance alone misses the point. The correlation between stocks and bonds is still positive. Rising and falling together eliminates the diversification benefit of the 60/40 portfolio.
Based on past data, correlation is returning to historic norms. Research by Bank of America shows that for most rolling 24-month periods since 1945, stocks and bonds have moved in sync.[3]
Another analysis by Schroders also supports this claim. While correlation between stocks and bonds have indeed been negative in the last 20 years, this was not the case for much of the previous 70 years.
Source: Schroders
The Cause
The previous two decades had low inflation, economic growth, low interest rates, and—in the latter half—extensive quantitative easing.
We now face a fundamentally different market environment, with higher inflation, shakier growth, higher interest rates and quantitative tightening.
Slower growth and a tighter money supply depresses the value of equities. Higher inflation decreases the likelihood of lower interest rates, meaning that bond prices are unlikely to offset a fall in the value of stocks.
The Bank of America analysis quoted earlier found six “lost decades” (negative real growth) for 60/40 investors since 1900, and we may enter yet another.
The Implications
The solution for this problem is to find a better source of growth and diversification.
Many investors are increasing their exposure to alternative investments, including private market investments such as private equity and private debt. The global alternatives market is growing and predicted to reach $23.3 trillion by the end of 2027 from $10 trillion in 2020.[4]
Alternative investments offer higher potential returns. From 2010 to 2020, private equity returns exceeded those of public markets after fees.[5]
Alternative investments also offer a hedge against market volatility that bonds no longer provide. Not being publicly traded, their performance relates more closely to the underlying businesses than market sentiment.
Moving Forward
Passive 60/40 strategies can still be pursued, but this environment requires a more active approach.
Incorporating alternative investments can be an effective investment strategy, but it requires more expertise than investing in broad asset classes.
Also, performance between alternative asset managers varies widely. The investments are only as good as the team that selects them. Working with a team that specializes in alternative investments, such as private markets, can add a layer of diversification to your portfolio, aiming to mitigate risk.
Did you find this article useful? Learn about the role of asset allocation in wealth management and the investment strategies in a high interest rate era.