(READ TIME: ~5 MIN)

TAKEAWAYS:

• The 60/40 portfolio has long been considered the "goldilocks" portfolio.
• Converging correlations between stocks and bonds over the past few years have left many wondering if the magic of a 60/40 is gone.
• Bonds are set up beautifully to bring the magic back to the 60/40 portfolio.

Some people are worried about the tried-and-true 60/40 portfolio.  It lost 17% in 2022 (its worst performance since at least 1937), and stocks and bonds have moved in tandem more over the past three years than at any time since 1997.  

What’s the Magic of a 60/40?

Figure 1 shows a portfolio composed of the Barclays Capital Aggregate Bond Index and S&P 500 Index allocated in 10% portfolio increments using average standard deviations and returns over the 65 years from 1950 to 2014.  The circle indicates the point at which the portfolio is invested in 60% equity (or stocks) and 40% bonds.  Risk for the 60/40 portfolio is slightly more than a 100% bond portfolio, but the annual return has increased from 6.47% for the 100% bond portfolio to 9.95% for the blended approach, indicating a considerably more efficient portfolio in terms of risk and return.  Figure 1 shows that Harry Markowitz’s efficient frontier still holds true 60 years later.  Harry Markowitz was the Nobel-winning pioneer of Modern Portfolio Theory.

Why has the 60/40 Failed Recently? 

The magic of a 60/40 portfolio depends on stocks and bonds being negatively correlated, meaning their prices move in opposite directions (i.e., when stock prices fall, bond prices rise, and vice versa).  While far more complicated in reality, the basic theory is that when the economy is growing and healthy, the Federal Reserve must periodically raise rates to keep the economy from growing too fast and becoming inflationary.  When rates go up, the value of bonds go down.  But every economic expansion meets a peak and usually ends in recession.  During a recession, stock values fall substantially as the outlook for company earnings decreases.  At this same time, the inflation risk diminishes, allowing the Federal Reserve to lower rates in an effort to spur economic growth.  When interest rates fall, bond values increase.  The best part is that bond values increase precisely when you need them to the most (when stock values fall and prices are “cheap”).

Economic cycles have been anything but ordinary since the Great Recession (2008-2009) when the Federal Reserve drove interest rates down to near zero.  The Federal Reserve kept them there until the first quarter of 2022.   By this time, inflation pressures had been building globally and then exploded as pent-up COVID-19 demand met a constrained labor market and supply chain, leading to a surge in prices.  As if this was not enough, Russia invaded Ukraine in February of 2022, sending fuel and food prices even higher.  

In an effort to combat inflation that reached its highest level since 1982 (at 8.5%), the Federal Reserve moved forcefully raising rates 11 times at the fastest pace in four decades, bringing them to a 22-year high of 5.50%.  Unfortunately, stocks and bonds were both casualties.  Stocks because investors feared the aggressive rate action would send the economy into a recession, and bonds because they drop in value when rates rise.   

The Magic of a 60/40 is Back! 

While painful getting here, the good news is that bonds are set up beautifully to serve as they generally do in a 60/40 portfolio when the economy is near a peak, with yields nice and high:

Today, investors get to earn great yields while they wait for the U.S. economy to stumble and stocks to fall in value.  Then, bond values will rise when the Federal Reserve starts to lower rates to help the economy.  Just in time to take advantage of the cheap stock prices.  The magic of the 60/40 is back!

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