The 60-40 asset allocation for portfolios has been the go-to strategy for decades, but is it the right mix to help you reach your goals?
Call it a classic. The investment portfolio of 60 per cent stocks and 40 per cent bonds has long been the standard-bearer for diversification and asset allocation, offering a blend of equity growth and steady fixed income.
The Origin of the 60-40 Portfolio
Often referred to as the ‘60-40 portfolio’, it was largely conceived by U.S. economists William Sharpe and Harry Markowitz, who won the Nobel Prize in Economics for the research on Modern Portfolio Theory.
Central to their idea was designing an optimal investment portfolio based on the total market universe.
And because that universe—or total market—had about $1.50 in stocks for every $1 of bonds, their theory could be implied to mean that a portfolio of 60 per cent stocks and 40 per cent bonds was the optimal asset allocation.
Why is it So Popular? A Strong Track Record
It’s an incredibly popular portfolio construction strategy for investors globally, and for good reason. Data show that from 1961 to 2021, the portfolio had an annualized return of 9.3 per cent. In contrast, stocks’ average annual return was 10.3 percent while for bonds, it was 6.7 per cent. While stocks have performed better, their performance is more volatile. A 60-40 portfolio has provided investors similar returns with less downside risk, particularly given that when stock markets crash, bond values in a portfolio generally increase. That’s because interest rates typically fall to stimulate economic growth. While favouring stocks long-term due to the availability of cheap money to borrow, initially, falling rates boost bond values and help bolster the value of the 60-40 portfolio, smoothing out the ups and, most importantly, the downs.
Cracks Showing in its Construction
A 60-40 allocation has offered the best of both worlds for investors—an effectively balanced approach.
Yet cracks in this strategy had been evident for some time. The reason being that bonds had been in a bull market since the early 80s as interest rates trended downward eventually skipping along historical bottom for much of the last decade.
In turn, the bond allocation in a 60-40 portfolio—designed to be a ballast to falling stock prices—became increasingly less of a hedge to that risk. With each decline in rates, the risk of them going up again grew, putting the bond allocation at risk of a significant decline the longer the bull market in bonds continued.
That, in and of itself, is not problematic in an environment of mildly higher inflation driven by stock prices moving higher. After all, then, the 60-40 portfolio is working as it should.
That is until it doesn’t—like 2022, when stocks and bonds fell simultaneously as central banks hiked the lending rate at an unprecedented pace.
Beyond 60-40 to the Alternative Universe
This came as no surprise to well-heeled investors—like institutional investors, who have used the 60-40 structure as the backbone to portfolios. But recognizing risks, they have diversified large chunks of their overall portfolio away from publicly traded stocks and bonds into alternatives that include private debt and equity, real estate, commodities (including gold), cryptocurrencies, hedge fund strategies and infrastructure.
Many well-advised retail investors have positioned themselves similarly for some time too. Now more than ever, many other investors are looking for answers for their investments going forward after the 60-40 portfolio saw on average a 16 per cent decline last year.
Alternatives, Yes, But Not the Whole Solution
Allocations to alternatives are not a panacea, as 2022 demonstrates with many sectors in the space also suffering losses. Those include private equity and real estate—which saw steeper losses on average than equities and bonds. Yet other alt sectors, including infrastructure, private debt and hedge funds saw minor losses in 2023. And notably, commodities stood out as a top performing asset class, up 19 per cent last year. One year’s performance, however, is beside the point. The principal reason for investing in different alternative classes, given the diversity of returns they offer, is decorrelated returns from the stock and bond markets. Alts typically respond differently to a variety of economic and market environments, potentially protecting the portfolio against inflation, interest rate increases, and equity and bond market volatility. The chart below summarizes the period of 1989 to 1Q23 and the impact that a 30% weighting of alternatives has had on risk and returns.
Finding the Right Mix
The challenge for many investors is getting access to alternative assets that typically only large investors can. That is changing with a greater number of liquid alter funds—exchange-traded funds (ETFs) and mutual funds—offering alternative strategies. As well, high-net-worth individuals can look at private market deals not traded on exchanges. While the benefits, most notably de-correlated returns, make alts attractive, they often require expertise, an advisor who can also determine how much alternatives can take up of that otherwise 60-40 allocation of stocks and bonds in the portfolio.
Advisors can help find the right investments while helping you understand the risks, which include lower liquidity. That’s even the case for liquid alternative funds—which are designed to be liquid. Yet the assets held inside them may be less liquid, leading to a risk that these could be sold at a steeper price discount in times of stress because they have fewer buyers.
Yet even beyond alternatives, advisors can help determine whether a 60-40 stock and bond portfolio is the right fit or not. For example, a risk-averse retiree is likely to need much less growth from equities and more income from bonds. In turn, a 30 per cent equity and 70 per cent bond portfolio may work well.
Even 60-40 portfolios can involve a lot of diversity given investors have a larger universe of stocks and bonds to choose from.
Again, expert investment management can help with those decisions to create a portfolio well-aligned to your goals, most notably retirement. If you are interested in learning more and finding the right portfolio mix for your unique financial situation, we invite you to contact our team today.