Does The 60/40 Portfolio Still Make Sense?

- Advertisement -


- Advertisement -

The 60/40 portfolio (60 percent stocks and 40 percent bonds) has been a standard strategy for investors, and for good reason. It is designed to balance growth and risk, with both allocations growing over time while offsetting each other. When stocks are up, bonds are down, and vice versa. This portfolio allows investors to participate in the market’s gains, but without too much of the downside.

Unfortunately, 60/40 portfolios had a terrible start to 2022, with the largest declines seen in decades. When interest rates started to climb, stocks dropped—which was expected. Unexpectedly, however, the bonds also declined significantly. Instead of one allocation offsetting the other, both dropped for the first time in decades. What was supposed to be safer turned out not to be. And if it isn’t safer, why do it? So, does the 60/40 portfolio still make sense for investors?

- Advertisement -

Will Rates Keep Rising?

If we expect the sharp rise in interest rates this year to keep happening every year for the next several years, then one might argue the 60/40 portfolio no longer makes sense. After all, the reason the model broke was the unprecedented spike in rates. But if rates don’t keep spiking, then the model works again. What the market is telling us is that rates should not keep spiking.

Let’s look at the interest rate on the 10-year US Treasury note. With inflation at more than 9 percent, it still has stabilized under 3 percent. Clearly, over the next 10 years, markets expect interest rates to stay around current levels, on average. If interest rates don’t spike but instead move up and down with the economy, then we are back in an environment where the 60/40 portfolio can work.

A Normal Cycle

Stocks go up over time, as the economy grows and companies earn more money. But during a recession, they go down as expected earnings decline. During a recession, though, the Fed cuts interest rates and bond prices tend to rise, offsetting the pullback in stocks. As long as the economy and interest rates move within a normal cycle, that relationship allows a 60/40 portfolio to work.

That normal cycle is the key here. What we got with the pandemic and its aftermath was anything but a normal cycle. The Fed cut rates to zero, and Congress dumped money into the economy. The drop in rates made bonds worth more as stocks tanked—but then stocks rebounded strongly even as bonds remained expensive. Now that interest rates are normalizing though, so have valuations, for both stocks and bonds. Rather than a gentle adjustment, we saw a shock and then a reversal. The shock made investing more attractive to investors, but the reversal hurt (a lot). It is this reversal that is making people wonder whether the 60/40 is dead.

As noted, things are normalizing. Stock valuations are back to where they were before the pandemic, as are interest rates. Absent another pandemic, there is no reason for another shock. With both valuations and rates back to where they were, the 60/40 portfolio should be as applicable now as it was then.

The Risks

The one real risk factor here is whether we do see another spike in rates. Given the multi-decade highs in inflation and the fact that markets expect the Fed to hike sharply, one could argue that most of the risks are already priced in. Indeed, long-term interest rates support that conclusion. Is there some risk? Perhaps. But it is likely more than offset by opportunities for rates to drop as well.

The Tradeoff Can Resume

So, does the 60/40 portfolio still make sense? As usual, the headlines are fighting the last war. The time to worry was when rates were cut, not now. Now, rates are high enough that the tradeoff between stocks and bonds can resume—just as the 60/40 portfolio expects.

Credit: www.forbes.com /

- Advertisement -

Stay on top - Get the daily news in your inbox

DMCA / Correction Notice

Recent Articles

Related Stories

Stay on top - Get the daily news in your inbox