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Mark Twain and the 60/40 Portfolio

by M. Burke Koonce, III

One doesn’t have to be a professional investor to know that markets have been under pressure so far this year. Rising interest rates and troublingly persistent inflation have contributed to a significant re-pricing across both the equity and fixed income markets, and with the S&P 500 in a bear market, bedrock assumptions about investment strategy tend to get called into question. Among the questions percolating through the investment zeitgeist now is the future of the venerated 60/40 portfolio, which has just suffered through its worst first-half performance in 34 years. Is the standard portfolio of 60 percent equities and 40 percent bonds, considered the classic allocation for decades, still an important idea? Or is it, as it seems half the internet would like to proclaim, dead?

For decades, a 60/40 portfolio has been considered if not the cornerstone of diversified investing then certainly a major component. The 60/40 conversation is perhaps the most common starting point for any investor evaluating his or her goals, risk tolerance, and income needs. The portfolio’s usage is perhaps even more common as a baseline for endowments and foundations than it is for individuals, and it is extremely common for individuals.

The attractiveness of 60/40 was that it would capture the majority of equity returns but with the lower volatility and higher income associated with fixed income returns. While an allocation of 100 percent toward equities is theoretically the better way to build long-term wealth, not every investor is positioned to handle the volatility, especially those with shorter time horizons or with income requirements.

Unfortunately, many investors in 60/40 portfolios this year have experienced plenty of volatility in their equity allocations but with minimal protection coming from the fixed income allocation. That’s because rising rates have caused significant price declines not just in the stock market but in the bond market as well. So is now the time to make big changes?

Almost certainly not. It’s not like this is the first time the 60/40 model has come under criticism.

Those of us who are old enough to remember the 2000s recall a decade of disappointing equity returns. “The Lost Decade” in stocks started with the dot-com bust and then as an encore gave us the Great Financial Crisis. The 60/40 portfolio returned just 2.3 percent annual during that time, and market mavens proclaimed that the portfolio was going the way of the dodo. Then, as if on cue, 60/40 proceeded to return 11.1 percent annually from 2011 to 2021.

So this year, as returns are negative across the board, 60/40s critics have returned en masse. This time, it’s not because of equity underperformance but because of either the paltry yields offered up by fixed income or because of fixed income underperformance.

That’s why we think that reports of 60/40’s death are, to paraphrase Mark Twain, greatly exaggerated. First, it’s fair to point out low yields in the bond market, and it’s fair to note that bond returns have been negative this year, but it’s not entirely fair to point to both. That’s because as yields rise, bond prices fall but future returns improve. Barring default, the mark-to-market losses showing up in bond portfolios will reverse over time as bonds accrete and mature and as proceeds get reinvested at higher rates. It’s essential to remember that as long as a bond investor’s time horizon is greater than the duration of the portfolio, rising rates boost returns.

Managing duration is also an important component of equity investing, and it’s mainly accomplished by maintaining a value tilt—avoiding overexposure to stocks with exorbitant earnings multiples that require years of earnings and dividend growth to achieve adequate returns, not just on capital but of capital. Stocks normally have much higher duration than bonds, which is why it’s essential to play the long game and moreover, it’s why having an allocation to bonds, say, a 40 percent allocation, is often so desirable.

There have been many articles written this year about the growing place for alternatives in portfolios. While alternatives such as private equity and private credit are theoretically desirable for well-heeled investors, it’s not really realistic to think that converting a 60/40 portfolio to something like 33/33/33 could have been responsibly allocated within six months’ time, not to mention that moving from public equity and public credit to private equity and private credit is not going to provide a completely different risk/return profile. One of the benefits of alternatives is the forced discipline that comes with a longer time horizon, but alts investing is still going to be, at its core, equity and credit.

Again, as long as one’s time horizon is longer than one’s portfolio duration, rising rates are a godsend—allowing the investor to reinvest at higher rates in the bond market and at lower multiples in the stock market.

Lastly, another significant benefit to a balanced portfolio, it’s 60/40, 70/30 or 80/20, is that it gives the investor two important weapons to use during a significant drawdown. The first is the capability to rebalance in favor of equities during a downturn. The second is that during truly adverse conditions either in the market or during one of life’s emergencies such as a loss of employment, it is generally preferable to liquidate bonds instead of stocks and avoid either losing future gains or paying taxes on capital gains.

So, is 60/40 dead? That sounds like an exaggeration.