by David Robertson, CFA, Areté Asset Management
Is it time to retire the 60/40 portfolio?
If ever there was a mantra in the investment world, it is that you have to diversify. Everyone knows that combining uncorrelated assets into a portfolio reduces the risk of destructive drawdowns. For several decades now, the iconic way to realize diversification in investment portfolios has been through a balance of 60% stocks and 40% bonds (60/40).
This approach has worked brilliantly and has allowed countless investors to sit back and watch their retirement dreams come true comfortably. Unfortunately, those halcyon days are coming to a close. It is time for investors to start considering alternative ways to balance their portfolios.
The 60/40 Model Worked
There is no doubt that the 60/40 model has worked. Phil Lynch of Russell Investments, for example, shows that between 1926 and 2019, “a balanced 60/40 global stock/bond portfolio has provided competitive returns …” According to investment bank Goldman Sachs, the Financial Times adds: “A US 60-40 portfolio in the decade to 2020 produced its highest volatility-adjusted returns in over a century.”
There is a caveat, however, and it is one that many providers of investment services use to make a point. Those attractive returns have only been “for investors who stay invested during turbulent markets.” The message is that if you even so much as think about getting out of the market, you risk forfeiting handsome returns.
It is not good to jump out of the market at just any little hint of turbulence. But nor is it a good idea to assume that the landscape never changes and that risk and reward are static. Indeed, a great deal of evidence is accruing that now is precisely the time investors and advisors should be carefully re-assessing the strengths and weaknesses of the 60/40 strategy.
For starters, the historical performance of the 60/40 portfolio is considerably less robust than it first appears. Chris Cole from Artemis Capital Management points this out in a terrific piece of research entitled The Allegory of the Hawk and Serpent (h/t Grants Interest Rate Observer). He highlights:
“A remarkable 91% of the price appreciation for a Classic Equity and Bond Portfolio (60/40) over the past 90 years comes from just 22 years between 1984 and 2007.”
In other words, the performance for other periods was much less impressive.
The Cracks Appear
Also, further cracks in the case for the 60/40 appeared earlier this year. According to the FT, “the 60-40 strategy suffered one of its worst performances since the 1960s, as the bond rally proved insufficient to offset the tumble in stocks.”
While instances of bad performance happen, and stocks were undoubtedly part of the problem, it was especially unsettling that bonds did not do their job this time.
The monetary policy response to Covid-19 in the first quarter also exacerbated challenges. The FT added:
“Covid-19 has brought us to a historic turning point in financial markets. A fundamental investment strategy that has protected institutional and retail investors alike for decades — balancing equity risk by holding high-quality government bonds — has finally run its course. When the Fed lowered short-term rates to zero in response to the pandemic, the last shoe dropped.”
In retrospect, it is easy to see why bonds provided such a powerful combination with stocks. Not only did investors receive insurance in the form of diversification benefits, but they also got paid for having that insurance by receiving coupons. It was one of the scarce instances in which investors got to have their cake and eat it too.
That blissful situation has changed, however, and the FT goes on to describe how:
“Now that double benefit has turned into double jeopardy. As main central banks have lowered interest rates towards zero over the past decade, the yield component of the return on a portfolio of government bonds has evaporated. That leaves capital appreciation as the sole source of future returns. But the room for prices to rise has arguably all but disappeared too.”
Investors must now face the music. Their beloved and productive 60/40 strategy can no longer accomplish what it has achieved for so long. It will be missed.
“For investors who hold the classic 60/40 portfolio, this is a disaster. They have lost a reliable source of return, and their diversification strategy is broken.”
This difficulty is raising questions by investors of all types. Rusty Guinn from Epsilon Theory reports, “What is fascinating to me is that within a week, a professional market research shop, a personal finance writer and a financial markets journalist all took on the question of ‘the role of bonds’.”
“But I can observe that enough people are thinking about it – and enough people know that other people are thinking about it – that common knowledge is forming around the question.”
In other words, the issue of the role of bonds is becoming a thing. It is undoubtedly a thing among fund managers as the FT notes:
“Investors are now grappling with the implications. In Bank of America’s investor survey in March, 52 percent of fund managers said that US government bonds were the best hedge against turmoil. That share dropped to 22 percent in April.”
The Role Of Bonds
The fact the industry is discussing the role of bonds is good news in the sense that the industry is adapting. However, it also means that if you are not working through these things yourself, you fall behind the curve.
More is needed than just discussion though. Identifying specific alternatives to take the place of the diversifying role of bonds. The FT offers some suggestions, some of which are simple and some of which are a lot more complicated:
“In seeking new sources of ballast for balanced portfolios, asset allocators will have to think about alternatives to bonds, including cash, gold, cryptocurrencies, and explicit volatility strategies — such as put options directly hedging equities — with which they may be less familiar. There are pros and cons to each selection, but the key point is that, with the diversifying power of bonds gone, there is no longer any natural choice.”
These ideas are extremely helpful in framing out possible replacements for bonds in balanced portfolios. Managing expectations is important. These replacements are unlikely to provide the same types of returns that bonds have, but they are less likely to offer the same diversifying effect as bonds have. On top of all that, some of these options are unfamiliar and uncomfortable for some investors.
The Days Are Numbered
While the days of the 60/40 strategy are numbered, the more general lesson to keep in mind is that things always change. Therefore, it is important to remain flexible and open-minded to deal productively with those changes. As John Hussman explains, these traits are likely to be extremely important in dealing with investment challenges ahead:
“That ability to respond to changing market conditions in a disciplined way is the one thing that passive buy-and-hold investors don’t have. I strongly believe that it’s the primary factor that will determine investment success over the coming decade. Lacking a flexible discipline, my view is that passive investors are doomed to go nowhere in an interesting way over the coming 10-12 year horizon.”
So, it’s never easy to replace something that has worked well for a long time. In this sense, replacing the 60/40 strategy is like bidding farewell to a retiring star athlete. We can all remember and respect the terrific accomplishments of the past and recognize that younger players are now more capable of competing at the highest level. Overly sentimental attachments will prevent progress; it is best to make the change and move forward.