The Case for the 60/40 Portfolio’s Survival – In Two Charts

The 60/40 investment rule of thumb has been killed and revived many times over the years.   

Now, with equities (the 60) and fixed income (the 40) both seeing drops in value, that strategy is again being brought into question. There are louder calls for a more tailored mix of weighting in portfolios, including alternative investments such as real estate investment trusts (REITs), or even, due to higher interest rates, old school certificates of deposit (CDs).

The investment research firm The Leuthold Group, based in Minneapolis, this October took a deep dive into the asset allocation for both a historic look, as well as considerations for the future. They didn’t come down definitely on the side of 60/40, but they do argue that, for long-term investing, it continues to show its value.

It’s true, Research Director Scott Opsal writes in the report, that “the 60/40 strategy is having a terrible 2022.” The results are clear in first chart below, which shows annual returns of a 60/40 stock and bond mix, with a stark drop in both this year.

Source: The Leuthold Group

Even so, the chart shows that, despite a bad year, the 60/40 strategy has worked pretty well over time.

“Since 1976 there have been nine years when the 60/40 portfolio posted negative returns,” Opsal writes. “Three of those years barely registered negative, and three others stopped short of a 5% overall loss. The only two annual declines of more than 5% came in the depths of severe equity bear markets in 2002 and 2008, and in both cases, bonds delivered positive returns to temper the overall loss.”

Then came this year, when values of both dropped together significantly.

What Next?

The question, then, is how to determine whether this is a blip in an otherwise good strategy, or a turning point. To get an answer, Opsal analyzed the “expected” returns for 60/40 investing over time. He then matched that to the year-by-year performance.

He found that the realized returns on stocks and bonds were “well above expected returns quite often in recent years, as signified by bars that reach higher than the green line.”

Source: The Leuthold Group

Through the research, Opsal estimates that rising valuations “boosted actual annualized returns almost 3% above expected return from the end of the 2002 Tech crash through 2021.” Even with this year’s drop, the excess return over expected returns over the last 20 years is an annualized 1.5%.

Going forward, returns may be even better, according to Opsal. The current falling stock valuations and rising bond yields have lifted estimated returns in a 60/40 mix to 6.9%, which “has greatly improved the attractiveness of 60/40 going forward.”

That said, the firm also notes that stocks and bonds tend to have the same sensitivity to inflation and interest rates, and opposing sensitivity to economic growth and unemployment. In short, “when inflation and interest rates dominate the conversation [today], we should expect a positive sign on correlation,” or more risk for market declines.

If a situation like the current one returns, “investors may be less willing to hold large allocations to equities when they are feeling bearish,” Opsal writes.

Alternative Options

The rise of Target Date Funds (TDFs), an age-based investment that generally allows for more risk when a saver is younger and gets more conservative over time, shows that many people know the 60/40 mix is not a one-size fits all. TDFs have grown in popularity in recent years, particularly among younger 401(k) participants, according to May research from the Investment Company Institute (ICI) and the Employee Benefit Research Institute (EBRI).

Many are also taking advantage of this moment to point out the need for alternative investments in portfolios, and research shows financial advisers are taking note.

Milind Mehere, founder and CEO of New York-based Yieldstreet, a digital wealth platform for alternative investments, says this is the natural evolution of investing.

He argues that institutional investors have already made the move to alternative investment strategies, and now the general public should have access as well.

“What we are really telling our investors is that you have to start modernizing your portfolio away from 60/40,” Mehere says. “Institutional investors are more than 50% locked into alternatives, but retail investors are just 5% invested in them. We need to start moving from 60/40 to 50/30/20 or something along those lines.”

The researchers at The Leuthold Group note in their report that, as with most investment decisions, timing will be everything.

2022 proved that “commentators were rightly skeptical about the strategy’s future prospects,” Opsal writes. “However, having experienced a record correction this year, the 60/40 is once again priced to deliver reasonable expected returns, albeit with more volatility caused by a diminished benefit from diversification.”