How To Fix The Faulty 60/40

How To Fix The Faulty 60/40
Reda Farran, CFA

over 1 year ago4 mins

  • Stagflation fears and rising interest rates have weighed on the 60/40 portfolio: it’s set for its worst quarterly performance in decades.

  • A simple trend filter on each of the two components of the 60/40 portfolio could improve on the strategy by lowering volatility and drawdowns, while keeping returns intact.

  • You can incorporate the trend filter concept no matter how you split your portfolio across asset classes.

Stagflation fears and rising interest rates have weighed on the 60/40 portfolio: it’s set for its worst quarterly performance in decades.

A simple trend filter on each of the two components of the 60/40 portfolio could improve on the strategy by lowering volatility and drawdowns, while keeping returns intact.

You can incorporate the trend filter concept no matter how you split your portfolio across asset classes.

Mentioned in story

With stocks and bonds both having been put through the wringer lately, the time-honored 60/40 investment strategy – 60% stocks, 40% bonds – is set for its worst quarterly performance in decades. But you don’t need to give up on the old faithful diversification strategy entirely: you just need to fix it up a bit.

Why is the 60/40 portfolio performing so poorly?

I explained a couple of months ago why the outlook for the 60/40 portfolio seemed bleak. In a nutshell, ongoing supply chain issues coupled with soaring commodity prices had led to fears that we’re on the verge of a new era of stagflation – that is, low economic growth and high inflation. This combination simultaneously undermines the prices of both stocks and bonds, draining the 60/40 portfolio of its diversification mojo.

Compounding the problem is that the US Federal Reserve – after initially being slow to respond to the highest inflation in 40 years – has begun hiking interest rates at its most aggressive clip in decades. Those higher interest rates are further dragging down stocks and bonds.

All in all, the 60/40 portfolio has plunged about 14% so far this quarter, according to Bloomberg. That’s worse than the performances it posted in the depths of the global financial crisis or in the once-in-a-century pandemic rout.

The 60/40 portfolio is set for a bad quarter – even worse than during the 2008 global financial crisis. Source: Bloomberg
The 60/40 portfolio is set for a bad quarter – even worse than during the 2008 global financial crisis. Source: Bloomberg

How can you fix the 60/40 portfolio?

One simple way is to incorporate a trend filter into the two main components of the 60/40 portfolio (stocks and bonds). The concept is simple: you invest in a particular asset if it’s in an uptrend, and you avoid (or sell) if the trend turns downward. You can do this using a simple technical indicator – for example, the 12-month price momentum, which measures the asset’s percentage price change over the preceding 12 months. If it’s positive, that’s an uptrend; if it’s negative, that’s a downtrend.

Here’s how this would work: on the last trading day of the month, you’d first look to see whether the stock market’s 12-month price change (using some index or ETF) is positive. If it is, then you’d invest 60% of the portfolio in stocks. If it’s not, then you’d invest that 60% in cash, earning the prevailing interest rate. Then you’d do the same with bonds: you’d invest 40% of the portfolio in bonds if their 12-month price change is positive; otherwise you’d invest that portion in cash. You’d then hold everything until the last trading day of the following month, and repeat the process.

How would such a strategy have performed in the past? I tested this over the past 45 years using data downloaded from Bloomberg. I used the total returns on the S&P 500 for stocks and the total returns on the Bloomberg US Aggregate Bond Index for bonds. For cash, I used the effective US federal funds rate – a good proxy for the returns earned on cash. Here are the results:

Investment performance of the classic 60/40 investment strategy vs. one with a trend filter. Source: Finimize
Investment performance of the classic 60/40 investment strategy vs. one with a trend filter. Source: Finimize

Measured over the past 45 years, the two versions of the 60/40 investment strategy generated virtually identical average annual returns of almost 10%. But their risk profiles were very different.

The annualized volatility of the trend-filtered 60/40 portfolio was 8.0% over the same period – significantly lower than the classic 60/40 portfolio’s 9.6%. In other words, the 60/40 portfolio with a trend filter generated higher investment returns per unit of risk.

Another important measure for assessing a strategy’s risk is maximum drawdown (MDD): the largest peak-to-trough decline in the value of a portfolio. Using a trend filter cut the 60/40 portfolio’s MDD by more than half: it displayed a maximum peak-to-trough decline of 17% compared to the classic version’s 37%.

Why stick with the portfolio at all?

The 60/40 is a time-honored investment strategy that’s performed well in the past. But many investors abandon even the best strategies when they start to experience big investment drawdowns. That’s why it’s important to control risk and avoid big losses: it not only leads to better investment results, but it also makes it more likely that you’ll stick with the strategy.

Historically, incorporating a simple trend filter into the 60/40 portfolio has lowered its volatility and investment drawdowns while keeping returns intact. And you’re likely to achieve similar results, regardless of how you split your portfolio across different asset classes.

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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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