Reports of the 60/40 portfolio's death are greatly exaggerated

In 1897, Mark Twain was driven by an erroneous newspaper article to famously assert that reports of him being at death’s door were exaggerated. In recent years, managers of balanced portfolios have had to battle a similar misconception. Some investors and financial pundits have expressed concerns about the efficacy of the traditional 60/40 (“balanced”) portfolio of stocks and bonds. They argue that bonds yield too little or that they will be too correlated with stocks. These claims got traction in 2022 when both stocks and bonds sold off and most balanced portfolios suffered significant drawdowns. Despite this short-term setback, we think the demise of the 60/40 strategy is, yes, exaggerated.

Balanced portfolios have their theoretical roots in the early 1950s, as modern portfolio theory (MPT) emphasized diversification to optimize risk-adjusted returns. Adherents of MPT promulgated the notion that a 60/40 strategy offers a more favorable risk-reward profile than either asset class individually.

Yet even good ideas (MPT won Harry Markowitz a Nobel prize) meet with skeptics, critics, and naysayers when conditions are less than ideal. Opinions on the 60/40 portfolio have risen and fallen over the years, usually in concert with fluctuations in rates, inflation and market performance.

Over recent decades, we experienced a period of peak inflation and rates, with inflation approaching 15% in 1980 and a 10-year bond yield that reached almost 16% a year later. Then we saw a prolonged period of disinflation, reinforced both by the globalization trend that saw China join the World Trade Organization in 2001 and by computer-boosted productivity growth. Bond yields broadly fell for more than 40 years while inflation stayed low. While there were notable weak periods for equities along the way, overall, both stocks and bonds saw robust capital appreciation for most of the time from 1980 to 2021. Few if any complained of positive correlation when both stocks and bonds were posting gains.

In the wake of the 2008-2009 Global Financial Crisis, the “new normal” of ultra-low rates prompted concerns about balanced portfolios both because yields were minimal and because it seemed that bonds must suffer when interest rates eventually normalized. Of course, that’s precisely what happened in 2022 when the Federal Reserve, facing the first serious inflation since the early 1980s, aggressively (if belatedly) set about hiking rates. Both bonds and stocks endured harsh selloffs, with the US Aggregate Bond Index down 13% and the S&P 500 down 18%. Importantly for investor opinion, bonds offered little diversification benefit that year. While other years that challenged 60/40 portfolios, such as 1974 and 2008, were essentially a case of stocks falling farther than bonds rose, both the “60” and the “40” sank in 2022.

Why we are optimistic

Given this recent harsh experience, what makes us sanguine about the future of 60/40 portfolios? First, we think the market environment is more attractive:

• Current rates are higher: Bonds are once again offering attractive yields. Overnight rates sit at around 4%, with investment-grade corporates about 100 basis points higher and high-yield credit another 250 basis points on top of that.
• Inflation’s hidden benefit: With inflation restored as a legitimate concern, bonds must offer more compensation (yield). This environment provides a better buffer during cyclical periods of rising rates.
• Correlation spike has faded: 2022 now seems an anomaly and, for the most part, stocks and bonds are no longer moving in parallel.

Second, critics of balanced portfolios often seem to assume a “plain vanilla” approach that bears little relation to what managers actually do. At Federated Hermes, we do not myopically adhere to a fixed 60/40 stock/bond allocation in our multi-asset strategies. Rather, we take an active approach that allows for tactical and strategic adjustments to balanced portfolios to take advantage of market dynamics. Also, we look beyond the indexes to further diversify into things like international investments, REITs and areas of the fixed-income market that offer risk-return profiles that differ from the aggregate. Nor is there a static list of asset classes to consider. As financial markets evolve, the list of potential investment opportunities to further diversify and optimize risk-adjusted returns seems certain to broaden too.

Balanced portfolios are as useful now as they ever were, offering much of the upside potential of growth portfolios over time with less of the downside risk. This profile encourages investment through market cycles, lessening the likelihood of the fatal but all-too-common practice of buying at highs and selling at lows. After all, peace of mind and the ability to sleep well at night are benefits that are never exaggerated.