It’s no secret that bond yields remain historically low, which is a byproduct of Federal Reserve policy and market-driven dynamics. As a result, many market analysts are writing yet another obituary for the traditional “60/40 rule,” or investing in a portfolio comprising 60 percent stocks and 40 percent bonds.
The 60/40 portfolio is a classic asset allocation strategy that’s aimed at balancing the upside of stocks with the stability of bonds to, over the long term, take the edge off market volatility. Like most rules in finance, it isn’t doctrine. Still, the 60/40 portfolio has historically served investors well — both moderating volatility and adding growth. Now, some say this balanced approach is antiquated, given the valuation of stocks and the yields one can earn in bonds.
However, a red flag should fly whenever investors hear rumblings of a new investment paradigm. The 60/40 portfolio’s obituary has been written several times before; it was especially dead coming out of the Great Recession amid historically low interest rates. All the while, a balanced approach to investing has proven its durability — you could say its vitality. But even within the 60/40 framework, there’s room to “tilt,” or favor, certain asset classes to gear the portfolio in a way that acknowledges the shorter- to intermediate-term macroeconomic environment. Here’s what we mean.
Long-term performance of 60/40 portfolio
Since the end of the Great Recession in 2009, a generic 60/40 portfolio with investment-grade bonds experienced positive returns in 11 of the last 12 years, with double digit returns in eight of those years. That’s according data compiled by Northwestern Mutual’s portfolio management team.
Over the past 45 years we’ve experienced sustained periods of high and low inflation, high and low bond yields, recessions and wars. Over nearly half a century, the 60/40 portfolio generated negative returns through a rolling, five-year period just once — for the cohort who invested the first half of 2004 and sold in 2009. In all other five-year periods since 1976, a 60/40 investor enjoyed positive returns. Keep in mind, the portfolio recovered sharply following 2009 for investors who stayed the course.
Diversification isn’t pretty, but it works
Naysayers of the 60/40 portfolio argue it doesn’t make sense to hold bonds in a portfolio today due to record-low interest rates and a Fed aiming to taper and raise rates in 2022. Why not allocate your capital to higher yielding-asset classes? There are a few reasons.
The role of fixed income in a portfolio is broader than yields, or income. In addition to those regular coupon payments, fixed income helps secure liquidity and hedge risks. Regardless of current yields, investors throughout history have flocked to high-quality fixed income in periods of market duress. The asset class still functions as a relative ballast to steady portfolios in rough seas.
When it comes to maintaining liquidity, fixed income — despite low yields
Over nearly half a century, the 60/40 portfolio generated negative returns through a rolling, five-year period just once.
— functions as a middle ground between holding cash that (currently) loses purchasing power to inflation and taking on more risk in high-yield, lower-quality debt that can be as volatile as equities.
For Northwestern Mutual Chief Investment Strategist Brent Schutte, managing portfolios for long-term success in markets isn’t about making the “big call” or reaching for yield; it’s about avoiding the “big mistake.” That means building portfolios that can generate some upside in a host of market environments, rather than concentrating capital into a single outcome. As a result, well-diversified portfolios will undoubtedly contain asset classes that underperform (and may underperform for quite some time). Asset classes may fall into a slumber but rarely ever die. What’s discarded by markets one day often has its time in the spotlight again. In the early 2000s, for example, U.S. equities underperformed international and emerging markets. Prior to that turning point, international and emerging markets had been laggards.
Selling out of an asset class altogether because it has underperformed can put investors on their heels when it’s fashionable again. The practice exposes you to more risk, and you’ll potentially miss out on the upside at the other end. Diversification, the underlying principle of the 60/40 portfolio, isn’t always pretty but it’s effective over intermediate- to longer-term time horizons as a person accumulates and maintains wealth over the course of a lifetime.
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A modern take on the 60/40 portfolio
The 60/40 portfolio is still very much alive, but even the classics adapt to modern times. Blue jeans are still made from the same material they were in 1873, but the way they are cut or how they fit is constantly evolving. The 60/40 portfolio is a classic, but there are ways to make it a better fit for the times.
In our view, the 60/40 portfolio just needed a tilt to inflation-
“We’ve always encouraged investors to think more broadly and have equity exposure across market caps, asset classes, and regions of the world.”
fighting assets. Commodities have been in investors’ doghouse for some time, as they’ve largely underperformed both equities and fixed income over the past decade. But 2021 proved to be a turning point for this sleeping asset class, and it finished the year as the third-best performer. Commodities are positively correlated with inflation and tend to perform well even when equities in fixed income lags.
Within fixed income, professional money managers can buy debts with different maturities or allocate to different fixed income instruments, such as TIPS, or floating rate debt to position for rising inflation or interest rates. The principal value of TIPS rises with inflation and falls with deflation, as measured by the Consumer Price Index. A professional money manager can diversify fixed income across various maturities to lessen the risk to rising rates.
On the other side of the portfolio, many believe equities are too expensive and hamstring longer-term returns. When a person says “stocks are expensive” they’re typically referring to the S&P 500. Certainly, there are companies among those 500 that could be considered expensive. However, markets possess more depth and range than the S&P 500: Think small- to mid-cap U.S. stocks, or international equities. There are still sectors and asset classes that present relative value and opportunity for incremental returns in the coming years.
“It’s often assumed that the 60 percent equities allocation is the S&P 500,” says Schutte. “But we’ve always encouraged investors to think more broadly and have equity exposure across market caps, asset classes, and regions of the world.”
Again, this isn’t upending the 60/40 principle, but simply adding an emphasis or higher weighting to assets that tend to perform well at different parts of the business cycle given historical trends.
Trust the whole portfolio, not its individual parts
Regular readers of our market commentaries know we tend to reject hyperbole and absolutist proclamations about the market. Even in a low-rate environment. the traditional 60/40 model could use a facelift via commodities and TIPS to provide some hedging, and potential upside, in a low-rate, inflationary environment.
“The 60/40 portfolio is aimed for a buy, hold and rebalance long-term strategy,” says Schutte. “We also believe portfolio tilts and security selection adds value over time.”
In a nutshell: Don’t pull apart your portfolio judging the merits of each part individually. Think more about how they all perform together, and stick to the plan you have built with your advisor — not new paradigms. You’re in this for the long term, and that commitment doesn’t change, no matter what the stock or bond market does.
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