Is the 60/40 Portfolio Dead?
The 60/40 balanced portfolio model has been a benchmark of investment strategy for decades, but recently some experts have declared it dead.
In September, CNBC called the 60/40 portfolio “obsolete.” Barron’s followed shortly, saying that the 60/40 approach “hasn’t worked,” before continuing in November with a feature titled “The 60/40 Portfolio is Dead.” Kiplinger, Bloomberg, and Morgan Stanley have all concurred since.
What is the 60/40 Portfolio Model?
The 60/40 portfolio model is a method of asset allocation where 60% of the portfolio is invested in stocks while 40% is invested in bonds. The 60/40 portfolio was designed to capture the best of both worlds: capital appreciation from equities and a more stable income from bonds.
Is the 60/40 Portfolio Outdated?
Returns of the 60/40 portfolio over the past decades have been strong. For stocks, the 2010s were an outlier in terms of high returns with record-low volatility. For bonds, they rallied at record levels as interest rates fell to almost zero. Today, the market environment looks significantly different. The 60/40 portfolio is becoming increasingly unbalanced.
Traditionally, when stocks are in a bull market, the 60/40 portfolio is able to take advantage of rising stock prices, whereas when stocks begin to fall, the 40% allocation to bonds offers downside protection.
But 2022 has been an unusual year so far. Both the NASDAQ and S&P 500 have entered bear market territory and the fixed income tracking Bloomberg US Aggregate Index has fallen over 10% at the time of writing. A Bloomberg model tracking a portfolio of 60% stocks and 40% fixed-income securities has dropped about 10% from January to April 2022, so far enduring the worst year since 2008.
How have market dynamics changed? Correlation between stocks and bonds has began to shift. A 60/40 portfolio relies on structural negative correlation between stocks and bond yields, something no longer happening in the current market climate.
Today, US stocks are less diversified and are priced at historically expensive levels compared to the past 20 years. Even though the S&P 500 has fallen 14% since January 2022, it is currently trading at 20.9 times its projected earnings over the next 12 months, according to Bloomberg. That is still far above the average multiple of 15.7x over the past 20 years, and only slightly below the recent peak of 24.1x in September 2020.
In the S&P 500 Index, the substantial growth seen from the “FAANGM” stocks (i.e. Facebook (now Meta Platforms), Amazon, Apple, Netflix, Google, and Microsoft) has been a driving force in higher toal returns. These six stocks now account for over $9 trillion in market cap, or about a quarter of the entire S&P, while accounting for only 17% of the index just three years earlier.
From 2019-2022, returns from FAANGM stocks made up around one-third of the index’s annual return, indicating heavy concentration of the stock market. As these stocks have experienced choppy returns so far in 2022, relying on just these six stocks for equity returns may not be sustainable.
Fixed Income Instruments
Today, bonds are faced with some challenges such as lower yields, inflation, and a potential rising rate cycle. The result is an unbalanced portfolio increasingly driven by equity exposure and with potentially less diversification than before.
Fixed income instruments are inversely correlated to interest rates, i.e. the higher the interest rates, the lower the price of bonds. Therefore, the low-rate environment that the US has been experiencing has been a challenge for bond investors for some time.
Looking at the Bloomberg Barclays Multiverse Index as a proxy for the global bond market today, BlackRock reported a “4-and-4 environment” with less than 4% of bonds yielding more than 4%. Ten years ago, the share of bonds yielding more than 4% was 17.7% and just five years ago it was 7.5%.
Higher inflation can only compound this issue for bond investors. If inflation fails to stabilize in the near future, bond yields will likely continue to climb higher, meaning that Treasuries would not provide the same shelter from falling equity prices.
Due to labor supply issues, supply chain restraints, and a pandemic still impacting people and businesses globally, most experts do not anticipate inflation stabilizing as quickly as we would like.
Alternative Portfolio Models
If the 60/40 portfolio is outdated and unbalanced, what are options to add diversification and find new sources of potential returns?
J.P. Morgan’s 1Q 2022 “Guide to Alternatives” noted that allocating just 30% to alternatives in a portfolio can potentially increase returns, while also strengthening stability and minimizing risk in a portfolio in this economy. Keep in mind that alternative assets are often less liquid than stocks and bonds, or funds made up of stocks and bonds.
Unlike traditional investing which is generally a long-only strategy that targets securities that are expected to outperform the market, long/short strategies seek to target the entire market opportunity.
Having a “long” position in a security means that you own the security with anticipation of capital appreciation. A “short” position refers to the promise to sell a stock that you do not own, these securities are ones the investor believes will decrease in value.
Long/short strategies seek to generate returns by going long companies that will outperform and short companies that will underperform. This portfolio method allows investors the potential to generate returns on both sides of the market and tap into an opportunity that long-only investors cannot access – potential returns from price depreciation.
This material is provided for informational purposes only and should not be relied on as investment advice.