Don’t Give Up On The 60/40 Portfolio Just Yet

Don’t Give Up On The 60/40 Portfolio Just Yet
Stéphane Renevier, CFA

over 1 year ago4 mins

  • Historically, the 60/40 portfolio has been nothing short of extraordinary: it’s generated similar returns as a stocks-only portfolio, but with significantly lower risks.

  • While rising rates and inflation pushed the 60/40 through one of its most challenging periods, it’s likely to make a comeback when a slowing economy pushes Treasury bond prices higher.

  • When everyone is talking about the death of an asset class or a strategy, that’s often the best time to buy.

Historically, the 60/40 portfolio has been nothing short of extraordinary: it’s generated similar returns as a stocks-only portfolio, but with significantly lower risks.

While rising rates and inflation pushed the 60/40 through one of its most challenging periods, it’s likely to make a comeback when a slowing economy pushes Treasury bond prices higher.

When everyone is talking about the death of an asset class or a strategy, that’s often the best time to buy.

That much-touted, trusty old go-to portfolio strategy – the 60/40 – has been falling out of favor with investors lately, mostly due to the fact that it’s suffering through one of its worst years on record. But that’s precisely why it’s a better alternative to holding stocks alone.

How’s the 60/40 portfolio supposed to work?

The 60/40 portfolio (60% invested in stocks and 40% in Treasury bonds) is the starting point for many long-term investors. In fact, this is frequently the benchmark to beat for professional investors. The idea behind it is as follows: stocks will drive your long-term returns, while Treasuries will bring some balance, protecting you against a steep drop.

And looking at its historical returns (using portfoliovisualizer.com’s backtesting tool), it’s fair to say its performance has been nothing short of spectacular: since 1972, it’s generated similar returns to stocks (9.3% per year vs 10.3% for stocks). And if you look at its performance over any five-year period (red line), it has easily rivaled that of a stocks-only portfolio (blue line).

Annualized returns over 5 years periods
Annualized returns over 5 years periods

But its biggest strength is that it has achieved those returns with much lower risks. Its volatility has been one-third lower than that of stocks – so returns have been more stable. And it has suffered much smaller “drawdowns”, or losses, along the way:

Peak to trough drawdowns
Peak to trough drawdowns

If that’s not enough to impress you, look at its performance during past market stress periods:

Losses in stress periods
Losses in stress periods

Despite the 60/40’s long run of success, it’s now in the midst of one of the most challenging periods in its history. It’s because with inflation spiking and interest rates rising sharply from their lows, stocks and bonds are being hit simultaneously. See, high inflation reduces the purchasing power of any financial asset, while rising rates reduce the present value of future cash flows, whether they’re a stock dividend or a bond coupon. And if bonds can’t diversify a stock portfolio anymore, then many fear that the strong performance of the 60/40 might have come to an end.

So is the 60/40 good and truly dead?

When everyone starts talking about the death of an asset class or a strategy, that’s often the best time to buy. (And often the worst time to sell). That’s because most investors tend to flock to what’s performed best recently, and sell what’s performed worst. The worse an asset or strategy performs, the more investors abandon it, and the lower its price goes. But at some point, an asset can become “oversold”, and its price can drop so low that it draws investors back in, and in a hurry, sending prices shooting higher again. It’s one reason why some of the sharpest losses are followed by the sharpest gains. So with the 60/40 currently going through some of its worst losses ever, the opportunities associated with holding 60% in stocks and 40% Treasury bonds are becoming fairly tempting.

But there’s also an economic reason why you shouldn’t bury the 60/40 just yet. That’s because the environment that is pushing both stocks and bonds lower – rising rates and inflation – can’t last forever. At some point, higher interest rates will likely do what they almost always do: put too much pressure on the economy and push it into a recession. That’ll probably be enough to cool inflation down and allow central banks to cut interest rates, cushioning the overall blow to the economy. In that environment of falling growth, falling rates and falling inflation, Treasury bonds should perform really well and are likely to beat stocks significantly. In other words: high inflation has temporarily reduced bonds’ diversification benefits, but that won’t last forever. In fact, with rates and inflation so elevated and economic growth starting to dip, bonds arguably look very appealing right now.

Mind you, if inflation remains stubbornly high even as economic growth slows, the 60/40 would suffer as both bonds and stocks would struggle to perform. But in that environment, stocks would be likely to be hit even harder than bonds, dented not only by high inflation, but also by falling growth. And if on the other hand, a happy “soft landing” recession-avoiding scenario materializes, and the economy sees both high growth and falling inflation, then the 60/40 might underperform a stocks-only portfolio, but it would still likely generate strong returns (it’s 60% stocks, after all, and its bonds should benefit from lower rates and inflation). In short: you probably shouldn’t bury the 60/40 just yet.

What’s the opportunity here?

Don’t get me wrong: I’m not saying that the 60/40 portfolio is perfect, and I’m not saying it’s my favorite portfolio to own today. As I explained here, an even more diversified portfolio may be better suited to today’s uncertain times. But given the current attractive entry point for the 60/40, it does present more attractive risk rewards than a portfolio of just stocks. So if you own just stocks in your portfolio, now may be a good time to mix in the Treasury bonds. You can do so with the iShares 7-10 Year Treasury Bond ETF (ticker: IEF, expense ratio: 0.15%) or even the slightly higher octane iShares 20+ Year Treasury Bond ETF (TLT, expense ratio: 0.15%).

And if you own the 60/40 and have already been through the painful losses, don’t sell it now. High inflation might have brought the 60/40 to its knees, but it’s unlikely to kill it.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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