The 60/40 portfolio is widely regarded as a reliable portfolio construction method. It’s been a disaster for 2022. The stock market has fallen sharply, and bonds are breaking records for the worst performance ever. The real returns are even worse when inflation, which has eroded purchasing power, is added on top. The desire to abandon the 60/40 portfolio is enticing, but its long-term prospects are likely to be reasonably strong. If anything, the year 2022 has improved the long-term outlook for this portfolio construction.
The Rationale Of 60/40
The 60/40 portfolio is a tried-and-true “set it and forget it” portfolio in which 60% of long-term assets are invested in stocks, typically a diversified index portfolio, and the remaining 40% in bonds. The logic is sound. Historically, stocks have generated attractive long-term returns, but they are susceptible to significant short-term price fluctuations. These extreme swings can be difficult to stomach. Bonds have somewhat lower long-term returns, but they can provide portfolio stability. Everyone has different investment objectives, but a 60/40 portfolio provides exposure to the long-term attractiveness of stocks while arguably bringing the level of risk closer to what many investors can tolerate.
Even though 2022 is a terrible year for the 60/40, it has served its purpose to some extent. Bonds have performed better than stocks, so the 60/40 portfolio has performed better than stock-heavy portfolios. Second, a diversified stock portfolio, such as the 60/40 portfolio, has proven to be less risky than more speculative investments. Those with large allocations to specific assets such as growth stocks, tech stocks, or cryptocurrencies have generally experienced a disastrous 2022, whereas the 60/40 portfolio’s balanced exposure has performed better. Positive returns have been difficult to achieve in 2022, but the 60/40 portfolio construction method has lost less value than the majority of other methods.
Perhaps the 60/40 portfolio has better future prospects. First lets take bonds. The returns on a portfolio of high-quality, low-risk bonds are equal to their current yield if held to maturity, which is reasonably easy to predict. Holding a 10-year U.S. Treasury at the beginning of the year, one could have anticipated a return of approximately 1.5%. At current levels you might expect a shade under 3 percent . Returns on intermediate-level, high-quality fixed income have roughly doubled. Obviously, it took a lot of suffering to get to this point, but it indicates that the long-term outlook for certain fixed income assets is significantly brighter than it was six months ago.
Then, when it comes to stocks, it is somewhat more difficult to construct a solid forecast, but valuations are returning to more normal levels, offering the possibility of more reasonable returns over the next decade. Similarly, we could not necessarily have said this 6 months ago.
Abandoning the 60/40 portfolio today is akin to abandoning a store when all the products are potentially on sale or less expensive than they once were. There will likely be more volatility in the future, and it’s not certain that we’ve reached the bottom of the financial markets, but it’s likely that the terrible start to 2022 has set the stage for a better long-term performance than could have been anticipated earlier in the year.