The End of the 60/40 Portfolio: Where’s Asset Allocation?
The usual relationship between stocks and bonds is out of sync. For some, the traditional 60/40 portfolio is coming to an end, while for others it’s just another investment blow.
Investors understand the benefits of diversification and one way to achieve a balanced portfolio is to take the 60/40 approach – 60% stocks and 40% bonds.
Stocks and bonds tend to have an inverse relationship, so when one goes up, the other goes down.
It is a well-established way for investors to generate returns and protect themselves against market volatility.
Dan Brocklebank, Director, UK Orbis Investments, explains: “By dividing a portfolio between bonds and equities in a certain ratio, investors can generally reduce overall portfolio volatility without too much impact on overall average returns.
“When measured over long periods of time, equities can be expected to generate higher returns, but with these higher returns come greater volatility than the returns of an equity portfolio. obligations.
“By moving in the opposite direction to equities during periods of stock market weakness, they have played an ideal role as portfolio stabilizers for 60/40 (and similar) portfolios.”
Since the 1900s, the 60/40 has most often produced excellent real returns (the chart below includes the global standard in US numbers).
But James Norton, head of financial planners at Vanguard, says bond and stock prices sometimes fall at the same time.
“When we looked at market data covering the 20 years before the pandemic selloff, we observed that this happened about 29% of the time,” he says.
He adds that there was also a drop both during the Covid 2020 selloff and earlier this year. Global equities are down just under 9% and global bonds are down around 8.5% year-to-date.
But it’s been the last six months or so that has challenged the 60/40 portfolio. Ben Yearsley, chief investment officer at Shore Financial Planning, said: “The traditional 60/40 portfolio has come under pressure this year for the first time in 40 years as the 40 invests in bonds, the price of which has fallen sharply since. six months now. .
“The 10-year US Treasury (government bond) is yielding nearly 3% now, compared to just half that at the start of the year. Rising yields mean falling prices With inflation nearing double digits, the prospect of further rate hikes is a certainty, so the 60/40 portfolio is under severe pressure as bonds fall in price at the same time stocks struggle.
Brocklebank adds that when yields rise, prices fall, and today, a 1% increase in 10-year gilt yields would cause prices to fall by 9%.
According to Waverton Investment Management, losses suffered by bondholders in the first quarter of 2022 were “historic” at -8.5%, which is the second worst since 1978. This highlights the perils of duration at a times of rising interest rates.
In addition, government bond total returns have been historically poor in recent months, reflecting the shift in sentiment on lingering inflation, Waverton adds. He said 2022 is expected to remain a tough year for bond investors.
Why are stocks and bonds not in sync?
But it’s not just inflation that distorts the usual 60/40 relationship. Brocklebank says bond and equity markets started 2022 with high valuations relative to long-term averages.
“In recent years, the valuations of many high-growth and often not-for-profit technology companies have reached particularly high levels as investors sought exposure to these names in the belief that their disruptive potential would ultimately be rewarded with further appreciation. share price,” he said. .
It also refers to Russia’s invasion of Ukraine. “While not a direct cause of a change in valuations, these shocking developments have reduced investors’ risk appetite and accelerated many of the ongoing trends by causing, or threatening to cause, shortages. actual materials that Russia or Ukraine export, such as energy, wheat and nickel.
For William Dinning, CIO of Waverton Investment Management, while they “have been talking about the death of the 60/40 portfolio for the last four or five years, this is actually happening”.
He says: “It is unfolding before our eyes. One of the most important implications of the persistently rising rate of inflation is that it is likely to change the relationship between stocks and bonds in terms of relationship.
Based on the chart above, Dinning explains that with long-dated index bonds losing double digits and the S&P 500 down 14% year-to-date, investors are “losing money in both” and that means the death of the bull bond market. .
“If inflation is consistently high, this correlation will turn positive. In other words, when the going gets tough, the stock and bond market won’t be able to beat inflation.
He adds: “When you think about it intuitively, it makes sense because if inflation is higher, what both markets are going to worry about is…the bond market is going to think interest rates need to go up and stock markets are thinking that inflation has already been consistently higher, so the bond market might be right. And in particular, it might be right because the central bank is going to keep tightening monetary policy and that’s bad for the stock market.
Brocklebank says, “For the past 30 years, the 60/40 has been as solid as a castle. Today it looks like a sandcastle.
Where now for asset allocation?
Dinning says that as a result of this relationship shift, it’s finally going to force people to think more creatively about how they put together their portfolios and what they consider low risk and what they think be diversified.
He adds that investors should not be underweight equities. “You should be pretty neutral in equities and continue to be underweight bonds and think about how you manage your alternative allocation. And actually, it’s probably not a bad time to hold some more money” , he said.
For Yearsley, he says the answer lies in alternatives such as real estate, private equity and hedge funds.
He says, “Having a bit of everything is always a good plan. But what I particularly like is the renewable energy space alongside a few other real estate investment trusts and specialist REITs. These provide physical asset support, good in times of high inflation and often the income from the underlying investments is often linked to inflation.
“These are stocks, so they will be more volatile than bonds, but at the same time they offer good diversification. You can either buy a fund like Time UK infrastructure revenue or Alternative Income RM or buy the underlying trusts.
However, Norton says nothing has fundamentally changed and investors shouldn’t change the way they invest.
“The current rise in bond yields is generally good news for those who hold a mix of stocks and bonds. And stocks are really important, most people can’t afford not to invest in them.
“The best thing to do is to do nothing. Overall, bonds still behave differently from equities and continue to act as important shock absorbers. On average, when equities have performed very poorly, government bonds have still helped to protect the portfolio and the more severe the decline in equities, the better the performance of the bonds,” he said.
Data from Vanguard that looked at stock and bond returns between 1900 and 2020 found that bonds earned a nominal average annual return of 5.6% while equities returned 9.17%.
However, once adjusted for inflation, bonds returned an average of 1.96% while stocks returned 5.41% “showing that stocks are a good hedge against long-term inflation”.
But he adds that investors don’t get the average, meaning returns will be volatile. Additionally, he says it looks like inflation has already peaked in the US and the market expects it to be closer to 3.5% by mid-2023.
“While we believe inflation will continue to rise in the UK for a few more months, we expect it to be at a similar level to the US by mid-year. next, with a sharp drop in the first half of 2023.”
He says, “When things don’t work, we like to fix them. When it comes to investments, that means making changes to your portfolio. We believe this is the wrong thing to do. Volatility is an integral part of investing. Investors should stay the course unless there has been a change in their goals that necessitates a change in their portfolio.
For Brocklebank, he says investors need to consider what will work from today’s starting point.
He says: “With low bond yields, high stock valuations and rising inflation risks, the classic passive 60/40 seems unlikely to repeat its past success. In fact, any static or passive allocation seems unlikely to work as well.
“Although overall stock valuations are high, that does not mean that all stocks are expensive. Owning neglected and overlooked stocks has worked much better this year than paying for the perception of perpetual profitable growth. We continue to believe that buying businesses at less than their value is the surest way to avoid losses.
He adds that their Orbis Global Balanced Strategy has found opportunities aligned with three fundamental trends it sees playing out that have been exacerbated by Russia’s invasion of Ukraine: a global energy crisis, a global food shortage, and a resumption of the Cold War.
“Each of them represents a reversal of the dominant trends of the last few decades, and each could shape the world for decades to come.
“Targeting these opportunities while hedging overall market risk provides a low-risk alternative to bonds. Other low-risk assets, such as gold and inflation-linked bonds, can play a supporting role while providing a stabilizing effect in the portfolio and some protection against inflation,” he says.