Is the 60/40 Portfolio Still Right for Today’s Beginning Investors?
Financial advisors often urge young people who are just beginning to save for their retirement to invest 60% of their monthly savings in stocks and 40% in bonds. This “60/40 Portfolio” approach has been a mainstay of the investment advice offered by providers of company-sponsored 401K plans and Individual Retirement Accounts (IRAs) since these tax-advantaged savings plans became popular in the 1980s.
There were good reasons for this. For at least two decades, the 60/40 portfolio appeared to work well. That’s because in the 1980s and 1990s, stocks and bonds normally moved in opposite directions. In Wall Street jargon, they were “negatively correlated.” When one went up, the other went down. You can see this in Graph 1, which shows the behavior of the S&P 500 stock index (green line) and the 10-year Treasury bond index (orange line) in the mid-1990s.
Having both types of instruments in a portfolio helped smooth out overall performance, with losses in one asset offset by gains in the other. This is the essence of the concept of diversification, which means don’t put all your eggs in one basket.
Performance of the S&P 500 and the 10-Year Treasury Bond Index, January 1, 1994 – January 1, 1996
Source: Charles Schwab & Co.
Unfortunately, that inverse relationship stopped working during the 2008 Great Financial Crisis. All assets – stocks, bonds, commodities, and housing – moved down at the same time. Graph 2 shows that stocks (green line) and bonds (red line) were no longer negatively correlated during the worst of the crisis – they moved in lockstep downwards.
Performance of the S&P 500 and the 10-Year Treasury Bond Index, January 1, 2007 – January 1, 2010
Source: Charles Schwab & Co.
The point of a 60/40 portfolio is to use diversification to reduce risk and smooth performance. Diversification in this type of portfolio will only work if stocks and bonds always move in opposite directions. When this assumption turned out to be wrong, steel titan Andrew Carnegie’s oft-scorned maxim from 120 years earlier proved to be painfully true: “People say don’t put all your eggs in one basket – but that idea is all wrong. I tell you, put all your eggs in one basket, and then watch that basket."
In 2022 we once again see the stock, bond, and housing markets all spiraling down in value, while out of control inflation forces monetary authorities to raise interest rates. All the eggs are falling out of their respective baskets at the same time.
Worse, research now suggests that a 60/40 approach always underperformed. Looking at data going back to 1926, analyst Alex Shahidi wrote in 2012 that a 60/40 strategy moved in lockstep with an all-stock portfolio, so the 40% bond allocation in the 60/40 portfolio provided no benefit at all.
Shahidi and others argue that investors need to tailor investments to their economic environment. Shahidi suggests four combinations of four assets – stocks, commodities, inflation-protected bonds (TIPS), and normal bonds – for four environments: rising or falling growth and rising or falling inflation.
This amount of complexity might be dispiriting for novice investors who feel overwhelmed by all the jargon and the amount of work needed to get up to speed. But there is a way to outsource that demanding work to experts: invest in high-quality, actively managed mutual funds. You can determine which are the best funds by using ratings from firms like Morningstar and Lipper, which are credible and usually published in descriptions of the funds provided by 401Ks and IRAs.
In a turbulent time like the present, it is wise to take advantage of this sort of expert advice.