A member of our wealth management team analyzes the 60/40 portfolio – 60% stocks to 40% bonds. Learn about the longevity, potential volatility, and track record of this investment strategy.
Joshua P. Preiss, CFA®
Jun. 15th, 2022
Markets started the year with a broad sell-off as both stocks and bonds moved lower in tandem. Bonds had their worst quarter since 1982 and have fallen 7.42% through the end of April as measured by the Bloomberg US Aggregate Bond Market Index. Meanwhile, domestic equities as measured by the S&P 500, have fared even worse, falling 12.92% through the end of April. This downward move by both stocks and bonds has resulted in a traditional balanced portfolio consisting of a 60% allocation to stocks and a 40% allocation to bonds to draw down sharply to start the year. This drawdown across traditional asset classes has led some to wonder if the 60/40 portfolio should be rethought due to the asset classes within the portfolio all moving down in tandem.
Even leading into the recent Federal Reserve tightening cycle and the accompanying financial market volatility, many investment companies were telling investors that due to the lower rates of return in bonds as a result of low interest rates and the dampened equity outlook due to high market valuations, investors should begin rethinking their asset allocation in favor of including a slice to less traditional alternative asset classes. Much of this advice has proven to be misguided, as many alternative asset classes have moved with equities lower for the most part. Looking beyond short-term performance and focusing on the long-term track record of the traditional 60/40 portfolio shows it continues to be a solid base allocation for many investors, and it continues to withstand the test of time.
Moving Beyond the 60/40
The standard thesis of the 60/40 portfolio being dead presented by investment management firms has been that risk premiums offered by traditional asset classes such as treasury bonds, corporate bonds, and equities have been eroded to very low levels due to near-zero interest rates. For example, consider if treasuries offered only 1% yields, corporate investment-grade bonds yielded 2-3.5%, and earnings yields on blue-chip stocks were at around 3.5%-4.5%. Then a portfolio consisting of 60% stocks and 40% bonds would not be able to generate a return high enough to meet many investors’ financial objectives or keep pace with portfolio spending. Due to these lower prospective returns, proponents of moving beyond the 60/40 had been advocating for investors to move out on the security market line (as shown below) to fund their long-term financial objectives, specifically by investing in alternative asset classes such as high yield bonds, real estate, private equity, and cryptocurrencies. This approach to funding financial goals by moving beyond the traditional 60/40 was deeply flawed. It advocated increasing portfolio risk rather than managing portfolio inflow and outflows to compensate for the lower return environment. This flaw has played out harshly for investors in 2022, with alternative asset classes starting the year down as much as or more than bonds and stocks. For example, the S&P Listed Private Equity index was down 18.98% through April 29th, the most popular cryptocurrency, Bitcoin, was down 19.4% through the end of April, and the S&P High Yield Bond Index drew down 8.22% through the end of April. Going further out on the security market line did not provide ballast to the traditional 60/40.
The other argument for moving beyond the 60/40 portfolio into other asset classes has been moving into quantitatively driven strategic investment strategies such as long/short equity, market neutral or FX arbitrage strategies, or commodities to improve risk-adjusted returns. While YTD these have performed relatively well, they do not align with MFG’s investment philosophy of investing in cash flow-producing assets. For example, if you own a block of gold, after ten years, you still just own a block of gold whose value will be purely contingent on market forces at the time. If you hold a bond for ten years, on the other hand, you will receive the principal back when the bond matures and collect a nice clip of coupons which you can, in turn, buy more bonds with to generate additional portfolio income. Likewise, suppose you hold a stake in a business that produces a good or service. In that case, you generate a consistent stream of cash flows from the course of business, which can be reinvested to expand the business and generate more cash flows. MFG’s Discovery Stock Portfolio invests in businesses with high returns on invested capital. Over the long term, they can compound capital, potentially increasing the value of our ownership stakes in the business.
The 60/40 Track Record
Focusing on year-to-date returns emphasizes a very short time horizon when investors in a 60/40 portfolio tend to have very long investment time horizons of ten-plus years. A 60/40 portfolio has weathered the test of time, even accounting for the recent pullback, looking beyond the short-term performance and focusing on the long term. A hypothetically 60/40 portfolio, represented by fund XYZ, returned an annualized rate of 8.46% over the last five years, 8.73% in the previous ten years, and 7.13% in the last 15 years through the end of April. The chart below illustrates the growth of a buy-and-hold investment in the hypothetical fund over the previous 20 years, illustrating the power of buy-and-hold investing over long periods.
Whenever markets become volatile, pundits come out of the woodwork to tout their solution or the next big thing in investing to ease portfolio losses. While it may feel good to take action in the face of volatility, markets and investors ranging from Buffet to Bogle to Graham have shown that discipline, keeping it simple, and sticking with your strategies are essential to long-term investing success. Visit the wealth management page of our website to connect with our team for assistance in constructing and managing your financial portfolio.
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