Does the 60/40 portfolio still make sense?

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The 60/40 portfolio (60% stocks and 40% bonds) has been a standard strategy for investors, and for good reason. It is designed to balance growth and risk, with both allocations increasing over time while offsetting each other. When stocks are up, bonds are down, and vice versa. This portfolio allows investors to participate in market gains, but without too much downside.

Unfortunately, 60/40 portfolios had a terrible start to 2022, with the biggest declines seen in decades. When interest rates started to rise, stocks fell, which was expected. Unexpectedly, however, bonds also fell significantly. Instead of one allocation offsetting the other, the two fell for the first time in decades. What was supposed to be safer turned out not to be. And if it’s not safer, why do it? So, does the 60/40 portfolio still make sense for investors?

Will rates continue to rise?

If we expect this year’s sharp rise in interest rates to continue every year for the next few years, then one could argue that the 60/40 portfolio no longer makes sense. After all, the reason the pattern broke was the unprecedented spike in rates. But if rates do not continue to rise, the model works again. What the market is telling us is that rates should not continue to rise.

Let’s look at the interest rate on the 10-year US Treasury note. With inflation at over 9%, it stabilized further below 3%. Clearly, over the next 10 years, markets expect interest rates to remain, on average, around current levels. If interest rates are not skyrocketing, but rising and falling with the economy, then we are back in an environment where the 60/40 portfolio can work.

A normal cycle

Stocks go up over time as the economy grows and companies make more money. But during a recession, they fall as expected earnings decline. During a recession, however, the Fed cuts interest rates and bond prices tend to rise, offsetting the decline in stocks. As long as the economy and interest rates move in a normal cycle, this relationship allows a 60/40 portfolio to work.

This normal cycle is the key here. What we had with the pandemic and its aftermath was anything but a normal cycle. The Fed cut rates to zero and Congress pumped money into the economy. Falling rates boosted bond values ​​as stocks tumbled, but stocks then rebounded strongly even as bonds remained expensive. Now that interest rates are normalizing, so are valuations, for both stocks and bonds. Rather than a smooth adjustment, we witnessed a bump and then a rollover. The shock made the investment more attractive for investors, but the reversal hurt (a lot). It is this reversal that has people wondering if 60/40 is dead.

As noted, things are normalizing. Stock market valuations have returned to pre-pandemic levels, as have interest rates. Absent another pandemic, there is no reason for another shock. With valuations and rates back to where they were, the 60/40 portfolio should be as applicable today as it was then.

The risks

The only real risk factor here is whether we see another rate spike. Given the multi-decade highs in inflation and the fact that markets are expecting a big Fed hike, one could argue that most of the risks are already priced in. Indeed, long-term interest rates support this conclusion. Is there a risk ? Maybe. But that’s probably more than offset by opportunities for lower rates as well.

Compromise can resume

So, does the 60/40 portfolio still make sense? As usual, the headlines war last. The time to worry was when rates were cut, not now. Now, rates are high enough that the arbitrage between stocks and bonds can resume, as the 60/40 portfolio predicts.

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