BlackRock Inc., the world’s largest asset manager, suggests investors should abandon portfolios made up of 60% stocks and 40% bonds, a mix that has been a standard for six decades. This comes after the worst year for so-called 60/40 portfolios on an inflation-adjusted performance since the Great Depression. Moreover, in only one of the seven years since 2015 did either of the two asset classes offset losses in the other, and that was in the upside-down year of 2020 when a global pandemic struck.
There are a lot of moving parts in asset allocation, so it’s important to be clear about the issue. It’s not the precise numbers 60 and 40, as many investors use 50/50, 70/30 or other ratios. The point is to use fixed long-term allocations for stocks and bonds as benchmarks. That doesn’t mean other asset classes cannot be used for diversification, but they will be evaluated based on their correlation with 60/40, and their allocations will change depending on market conditions. And investors need not be wedded to the core allocation, as tactical adjustments might be made to the proportions. But performance will be judged relative to the 60/40 benchmark.
There are two main alternatives to 60/40. One is to use equities as a benchmark and treat bonds as just another asset class for diversification — like commodities, real estate, venture capital, alternative strategies and private investments. The other is to jettison the idea of a core portfolio and allocate assets based on some other principle, such as risk parity, Black-Litterman or Markowitz optimization.
A major flaw in the BlackRock analysis is to ignore valuation. Based on cyclically adjusted price-to-earnings, or CAPE, ratios for stocks, and interest rates for bonds, the attractiveness of 60/40 has been falling steadily since 2008. At the beginning of 2022, 60/40 investors were facing an exceptionally high 38.3 CAPE for the S&P 500 Index and a low 1.4% yield for 10-year Treasury notes. Actual inflation was 7%, but the market was pricing in future inflation of just 2.5%. When you buy expensive stocks and low-yielding bonds in a high-inflation environment, you can’t be completely surprised by a bad result.
Today, CAPE has fallen to a more moderate level of 28 and the 10-year Treasury yield is up to 3.5%. Inflation has slowed only slightly, to 6.5%, but the Federal Reserve seems much more determined to get it under control than in the beginning of 2022. Investors who flee 60/40 based on a bad 2022 may be making the classic mistake of selling at the bottom. It’s still less attractive than historically, but it’s expected real return is considerably higher than it was for 2022.
BlackRock did not rely solely on dismal 2022 performance and the reduced diversification value of bonds since 2015 for its call. One of the economic arguments for 60/40 is that the phase of the business cycle that causes stock prices to fall tend to bring lower interest rates, which help bonds. In addition to the natural relation between the markets, the Fed is apt to raise interest rates when stocks are going up, and cut them when stocks are going down, reinforcing the diversification value of bonds. This argument seemed strong during the Great Moderation that began in 1983 and ended in 2014.
But 2022 looked like a return to an earlier period in which inflation savaged both stock and bond returns, and the Fed seemed unable or unwilling to combat budding inflation. If you believe this to represent the future — an ineffectual Fed pushing up interest rates but failing to contain inflation, and that inflation along with other negative forces preventing robust economic growth — then 60/40 may be a volatile portfolio with weak returns after inflation. War, uncontrolled deficits, political disfunction, possible US government default sound more like the 1970s than what we have been used to since.
If there has been a regime shift in which stocks and bond are more likely to move together than in opposite directions, and inflation proves hard to kill, and investments respond more to war and politics than constructive economic activity, all core portfolios are endangered. But this sounds more to me like the PTSD of investors battered by a terrible year following a global pandemic than a sober assessment of the future.
I think 60/40 is alive and well. It’s no guarantee of financial success, but nothing is. The world of 2023 and beyond may be more chaotic than the Great Moderation, but that’s all the more reason to have a steady benchmark. Investors might want to dial the risk down a bit, say to 50/50, and put larger allocations into alternatives, but a long-term core allocation among the two most fundamental asset classes — with the most liquidity and lowest costs — remains a good idea.
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