Long-term investors following the age old 60/40 balanced portfolio strategy (60% in stocks and 40% in bonds) experienced surprisingly disappointing returns from this widely used portfolio structure in 2022.
After many years of providing attractive returns with relatively low volatility, the 60/40 strategy declined approximately 15% in value in 2022. This disappointing outcome was the third-worst performance year for this strategy since the Great Depression, and was almost as bad as 2008, when the markets were gripped by the collapse of the housing market and the accompanying financial crisis.
Assumptions behind 60/40
The 60/40 strategy is based on the assumption that there is a correlation between the relative performance of the broader stock and bond markets, and that this correlation is negative. In other words, when stocks decline, bonds are expected to rise in value as rates fall, or, at worst, hold their value, acting as a strong portfolio buffer. The strategy also assumes that this relationship works in reverse during strong stock market rallies, with bond prices declining or, at best, holding their value.
However, historical data shows that the performance correlation between the stock and bond markets is not static. In fact, the stock/bond relationship goes through long periods of negative correlation and long periods of positive correlation. Over the long span of history, yearly correlations actually tend to be positive, with stocks and bonds moving in the same direction. Finally, there is also significant variability around the strength of the correlation relationship in a given year.
From the mid-1970s through 2000, stock and bond market performance numbers were generally positively correlated. However, at about the turn of the century (2000), stock and bond market correlation flipped to being more negatively correlated, and the strength of this correlation relationship became much more volatile. This more negatively correlated stock and bond performance dynamic persisted for approximately 20 years until turning sharply positive again in the bear market of 2022.
The key variables to 60/40 performance correlation
During the 25 years from 1975 through 2000, when the correlation between stock and bond returns was generally positive, interest rates and bond yields were generally higher than the rate of inflation. That provided attractive positive real interest rates, which are the rates an investor receives after subtracting out the impact of inflation.
The Federal Funds rate, set by the Federal Reserve (Fed), averaged more than 7% during this 25-year time frame, while inflation averaged under 5%. Inflation and long-term interest rates also declined during this period, which bolstered returns on all financial assets. This resulted in historically positive performance for both stocks and bonds. The 60/40 strategy worked exceedingly well in this positively correlated environment, with positive real rates and declining nominal bond yields benefitting both stocks and bonds.
However, at the turn of the century, the Fed cut interest rates decidedly below the rate of inflation, as it dealt with a series of very challenging economic and financial stability issues. These included the Dot-Com stock market collapse in 2000, the banking crisis, induced by the implosion of the mortgage market in 2008, and finally the global pandemic in 2020.
From the early 2000s through 2021, the Fed Funds rate averaged approximately 1.5%, and was even pegged at effectively 0% during the pandemic, while inflation, as measured by the Consumer Price Index (CPI), averaged slightly over 2%. This policy of suppressing interest rates resulted in negative real interest rates. This unprecedented accommodative policy benefitted stocks, as price-earnings multiples expanded.
While bonds suffered from a lack of meaningful interest income, they still played a diversifying role as the returns were generally negatively correlated with equity returns. Bond yields tended to rally during periods of economic or market anxiety, such as during the Great Financial Crisis in 2008, market volatility in 2011, and during the COVID crisis in 2020. Through this period inflation was relatively low and often fell short of the Fed’s 2% target, which was adopted in 2012.
Clearly, inflation – and the Fed’s response to inflation with its impact on real interest rates – is a key variable in determining the direction (positive or negative) and the strength of the performance relationship between stocks and bonds.
Key takeaways of the traditional 60/40 strategy
- One year is too short a time frame to assess any strategy. Markets are exceedingly unpredictable in the short term. Diversified approaches, such as 60/40, have demonstrated their effectiveness over longer time frames in terms of satisfying overall portfolio goals. Diversification benefits are evident in longer periods of both positive and negative correlations between stocks and bonds.
- Although 2022 was a historically bad year for both the stock and bond markets, it does not negate the benefits of diversification. Furthermore, although the main culprit for disappointing 60/40 performance came from the lack of fixed income to provide a meaningful performance buffer, exposure to cash and short duration fixed income would have contributed to reducing volatility and offsetting steep market declines in the equity market. In essence, diversifying a little more with cash and adopting a more comprehensive approach to fixed income, rather than simply using the Bloomberg U.S. Aggregate Bond Index (a broad index of high-quality fixed income), would have mitigated market losses.
- Yield and income also are very important diversification elements in conjunction with negative return correlations. The past year began with historically low yields in the bond market. This lack of yield hindered fixed income as an asset that could provide some buffer to the sharp declines in the equity market. With the dramatic surge in bond yields – driven by Fed rate hikes – fixed income investments are now much better positioned to contribute to the diversification benefits of a portfolio on a forward basis.
The outlook for 60/40 and other diversifying strategies
The Fed has aggressively raised short term interest rates to 4.75% and seems poised to push them to 5.25% or higher. However, inflation remains stubbornly above 5%, thus real interest rates are about 0%, at best. For the Fed to be successful in its inflation battle, real Fed Funds rates, a short-term rate that the Fed controls, likely will need to move into positive territory and remain there until inflation declines to closer to the Fed’s target of 2%.
Rates over the past year already have moved up sharply, with the increase in Fed Funds in 2022 the largest annual move over the past 50 years. Long-term rates such as the 10-year Treasury rate have followed Fed Funds higher.
While the Fed Funds rate is likely to increase further this year, most of the increase in rates in response to inflation likely already has happened. Historically, higher Fed Funds and other rates slow the economy with a lag of a year or so, and a slower economy slows demand-driven inflation. We believe longer-term rates, which are driven in part by growth and inflation expectations over time, are likely to decrease if the economy meaningfully slows or enters a recession and inflation eases. In this scenario bonds could play a diversifying role to equities should equity returns suffer from lower earnings.
Regardless of the direction of stock/bond return correlations, the bond market once again has a meaningful income advantage over stocks. This is a very important element, which will provide much more of a benefit for diversified portfolios. Furthermore, money markets are now a viable asset class to allocate capital, with yields of more than 4% and extremely low volatility. Cash is once again an option for providing some stability and income to an overall portfolio.
Is the traditional 60/40 portfolio structure still relevant? Using multiple equity asset classes and sectors in a more strategic way may provide certain portfolio benefits over a simple S&P 500 allocation. These include potentially increased allocations to value, small/mid-cap, and even international stocks. Also, as mentioned, a more comprehensive approach to a fixed income allocation may be warranted, using cash, short duration, high yield, and even emerging market bonds, in addition to a heavier weighting in Treasury and investment-grade corporate bonds that dominate the Bloomberg U.S. Aggregate Bond Index.