60/40 Strategy Will Flop Fairly Soon, Paul McCulley Says

Portfolios consisting of 60% equities and 40% bonds have had an incredible run, both this year and over the long term.

However, with yields on long-term Treasuries near all-time lows, the chorus of naysayers toward the so-called 60/40 portfolio has grown. The criticism is based on the very reasonable grounds that you’re not getting paid much to hold bonds and there isn’t much scope left for capital appreciation.

But to understand the real risk to the 60/40 strategy, it’s first helpful to understand the dynamics that have made the portfolio such a winner all this time. The key is that in the short term, Treasuries and stocks tend to move inversely to each other. When people are bullish on risky assets, they tend to lighten up on safe-haven Treasuries. When investors are fearful and stocks are tanking, Treasuries tend to do well. This nice inverse correlation dampens volatility for the portfolio overall.

The other big reason 60/40 has done so well is that bonds have been in an incredible multidecade bull market. So while in the short term the two components balance each other out, over the long term both have gone up massively. Win-win.

According to Paul McCulley, a former managing director and chief economist at Pacific Investment Management Co. and now a faculty member at Georgetown Law, the dual bull market in bonds and stocks is the result of policies that started around 40 years ago and established, in his words, a “monetary policy dominant world” that crushed inflation at the expense of other economic priorities, such as full employment.