Why the 60/40 is Not Dead, Will Never Die, and Why You Can't Kill It

Or we can look longer term. How did 60/40 return against inflation in the two most extreme examples of inflation we’ve seen in modern times?

From 1973-1982, a period of near hyper-inflation, though the 60/40 model underperformed inflation, its average return was still more than 7% per year. During the 1987-1991 period when inflation was 4.4% yearly, the 60/40 model significantly out-performed its average return.

To build the case that inflation is bad for investing, no one would argue that real returns go down. That’s why fully diversified portfolios need inflation hedges like real estate and commodities. But it is counter-historical to say that the 60/40 portfolio will underperform in every inflationary cycle.

2. Returns

“Recall not all that long ago the infamous lost decade to begin the 2000s in which a 60/40 portfolio generated a meager 2.3% annual return and investors would have lost value on an inflation-adjusted basis,” cautions Goldman Sachs Asset Management.

This sounds bad until you learn that the S&P 500 lost .95% annually over the same period – a relevant data point that was curiously omitted.

What should have been a perfect example of the protective power of diversification, where 60/40 investors turned a negative return decade into a profit, with lower volatility, Goldman Sachs inexplicably called a “warning”?

Then there is the stocks and bonds are trading together so returns are gone story.

No, they aren’t.

Bank of America said this two years ago and keeps saying it. They are not alone. Others say the same – that the long-term secular bull markets in stocks and bonds are over, so bonds no longer add diversification value to a stock portfolio.

Again, this is not true.

Below are the three major fixed income indexes’ⁱ rolling three-month periods compared to the S&P 500, for the last 30 and last five years, to see if I had missed a recent trend. Note the low and even negative correlations in every comparison.

To verify that the problem was not my choice of rolling periods, I compared the S&P 500 with the Bloomberg Barclays U.S. AGG from 1976-2020. This was as far back as one can go with the Barclays AGG. The overall correlation between their returns was only .24.

What does this mean? Bonds have, are, and most likely will continue to be an excellent diversifier for stocks.

Conclusion? There is no diversification or return problem.

3. Interest rates

No one will be shocked to hear that we are in a period of low interest rates. A portfolio that holds 40% in fixed income naturally struggles to find yield in this environment. Luckily, yield is just one component of total return.

Nevertheless, seizing on this perceived weakness, the same Goldman analyst wrote, “Today, a 60/40 portfolio yields less than 2% – a far cry from 5%+ offered in the ‘70s, ‘80s, and early ‘90s.” His solution? Sell calls on the S&P 500 and buy puts on a Treasury bond ETF. Sure. Put down this article right now, call compliance and ask them to approve options trading for all your conservative- and moderate-risk clients. Let me know how that goes.

I will overlook the complications, risks, timing obstacles, and expenses that the average investor would face by attempting to implement that strategy.

It is unnecessary.

One of the oddest things I have seen in the investment industry is the perception that though we have a variety of well recognized equity categories – large, medium, small U.S. and non-U.S., emerging, developed, value, growth, multiple sectors, dividend stocks, etc. – we have but one bond market. I hear advisors say, “This is what bonds will do,” “Here’s what will happen to bonds when rates go up,” “There’s no reason to buy bonds at these levels,” etc.

There is not one bond market with one interest rate. By my count, in taxable fixed income alone there are 12 major categories. Each behave very differently with their 10-year correlation to other categories generally below .40. Here was the performance of the underlying index for each of the 12 categories in 2020: .54% to 46.07%.ⁱⁱ That spread of returns is wider than among equities in the Morningstar equity style box.

Would it be safer and more predictable to mix these categories of bonds into the fixed income allocation of a 60/40 portfolio, or to sell calls on the S&P 500 and buy puts on a Treasury bond ETF?

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Enough with what 60/40 is not. Just to show that critics are wrong does not demonstrate that 60/40 has merit.

Why, even though I manage a competing strategy to 60/40, am I so enthralled with 60/40? The 60/40 is the foundation upon which the entire investment industry is built. It is “risk-adjusted return” defined. You can quibble over whether 60/40, 65/35, or 70/30 is better – this depends on what period is being measured and how much risk an investor is willing to assume. But you will not find a more durable model in the history of investing than 60/40.

Oldest and biggest

The market, as measured by investor interest, may agree. Below are the 10 oldest mutual funds. Two balanced (moderate allocation) funds are on the list. They are significantly bigger than the competing funds. This is telling us something very important about investor preference.

I know it is tempting to say, “Well, just because it was then, doesn’t mean it will continue.”

Styles change, it is true, but investing objectives do not. What does not change is the desire for risk-adjusted returns.

This survey by advisor Lawrence Hamtil, is a great summary.

https://twitter.com/lhamtil/status/1449745434923126786

He asks, The purpose of a portfolio is to maximize returns, or minimize risks?

The poll got 1,122 answers: 63%, maximize returns – what stocks do, and 37%, minimize risks – what bonds do.

Roughly 60/40.

Those 1,122 anonymous people from all over the world quite naturally built a 60/40 portfolio!

I love it.

So do you.

Andy Martin is a mutual-fund manager, product developer, and author of Dollarlogic: A Six-Day Plan to Achieving Higher Returns by Conquering Risk, foreword by Arthur B Laffer, Ph.D.

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ⁱThe Bloomberg Barclays US Government Mortgage Total Return Index covers a broad base of mutual funds that specialize in investing in government and mortgage securities. This index is formed by grouping the universe of over 600,000 individual fixed rate Mortgage-Backed Security pools into approximately 3,500 generic aggregates. An investor cannot invest directly in an index.

The Bloomberg Barclays US Aggregate Total Return Index is an index comprised of approximately 6,000 publicly traded bonds including U.S. government, mortgage-backed, corporate and Yankee bonds with an average maturity of approximately 10 years. The index is weighted by the market value of the bonds included in the index. This Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-through), ABS, and CMBS. This index represents asset types which are subject to risk, including loss of principal.

The S&P 500 Index is a basket of 500 stocks that are considered to be widely held. The S&P 500 Index is weighted by market value (shares outstanding times share price), and its performance is thought to be representative of the stock market as a whole. The S&P 500 Index was created in 1957 although it has been extrapolated backwards to several decades earlier for performance comparison purposes. This index provides a broad snapshot of the overall U.S. equity market. Over 70% of all U.S. equity value is tracked by the S&P 500. Inclusion in the index is determined by Standard & Poor's and is based upon market size, liquidity, and sector.

The Bloomberg Barclays Global Aggregate Total Return Index is a macro index of global government and corporate bond markets, and is composed of various indices calculated by Barclays Capital, including the US Aggregate Bond Index, the Pan-European Aggregate Index, the Global Treasury Index, the Asian-Pacific Aggregate Index, the Eurodollar Index, and the US Investment Grade 144A Index. An investor cannot invest directly in an index.

ⁱⁱFederal Agency: BBgBarc US Agency TR, Conv/Pref: ICE BofA Convertible Bonds All Qualities, US Inv Grade Corp: BBgBarc US Credit TR, MBS: BBgBarc GNMA TR, Leveraged Loan: S&P/LSTA U.S. Leveraged Loan 100 TR, Emer Mkt: JPM EMBI Global Core TR, Non-US Corp: S&P International Corp Bd TR, TIPS: BBgBarc US Treasury US TIPS TR, Cash: BBgBarc US Treasury Bill 1-3 Mon TR, US High-Yield: BBgBarc US Corporate High Yield TR, Non-US Gov: BBgBarc Global Treasury Ex US TR, US Tsy: BBgBarc US Treasury 7-10 Yr TR. Past performance is no guarantee of future returns. Diversification does not guarantee a profit or protect against loss. Indexes are not investable.

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