I might be showing my age, but I still remember the scene from Monty Python and the Holy Grail in which the cart master is collecting dead bodies. A peasant tries to place a body onto the cart, but the not-quite-dead-yet victim protests “I’m not dead!”
I enjoyed that scene because for me, it underscores our collective tendency to declare (often prematurely) that a given trend has permanently ended. Remember “the era of big government is over?” Or “everything changed after Watergate (or 9/11, or the 2008 financial crisis)?” Or how about “Van Halen will never succeed without David Lee Roth?”
Yet big government is still around, large-scale societal changes are rarely permanent even after major crises, and Sammy Hagar helped VH create their best music and biggest-selling albums by far (trust me, you don’t want to argue with me on this point).
John recently mentioned that he had seen quite a few articles proclaiming the death of the 60/40 portfolio. The contrarian in me was intrigued. He was certainly right: a simple internet search of “60/40 dead” produced quite a few well-reasoned thought pieces from a number of different sources. But I remain skeptical that we can definitively mark the end of the 60/40’s usefulness, any more than we can conclude that value stocks, international markets, and inflation-sensitive assets (just to name a few) will never perform well again.
The appeal of the 60/40 portfolio (60% equities and 40% fixed income)
Historically, equities have tended to rise over time, so we’d expect them to drive long-term capital appreciation and therefore they should represent the majority of the portfolio. However, they do have this annoying tendency to exhibit unpredictable spasms of volatility, as we saw earlier this year. For that reason, an allocation to a diversifying asset class makes a lot of sense. Bonds would represent the portfolio’s stabilizer during stock market declines, as well as generating income to enhance the portfolio’s total return.
Indeed, the last 4 decades have been a very favorable environment for a 60/40 portfolio. In late September of 1980, the level of the S&P 500 Index was somewhere around 135. Fast forward to early September 2020, and it reached an all-time high (so far) of just over 3,588*.
And bonds haven’t done too badly, either. Back in late September of 1981, the yield on a 10-year U.S. Treasury Note peaked at nearly 16%. As of this writing, it stands below 0.7%*. Since yield and price have an inverse relationship, that translates to a very impressive multi-decade total return. Throw in the benefits of regular rebalancing, and it’s understandable that many investors consider a 60/40 to be the ideal “set it and forget it” approach, suitable for a wide variety of clients.
Pessimism may be driving the demise of the 60/40
So why is there so much angst today about this historically successful investment approach? The biggest concern seems to be pessimism about the strategy’s prospective returns. Bond yields are quite low. Since a good rule of thumb for estimating future bond returns is to look at the current yield to maturity, asset class returns are likely to be muted at best and possibly even negative. Equities looked like a strong buy after the first-quarter selloff, but they have rebounded dramatically from their March 23 lows, despite uncertainty about the global economy, corporate earnings and potential profit margin contraction. Conditions hardly seem supportive of the high-single-digit returns to which investors have become accustomed. Some argue that we’ll be lucky to achieve positive returns, period.
I believe that these concerns deserve serious consideration. At the very least, the current economic and market environment should cause us to reexamine and possibly ratchet down our expectations for future asset class performance. However, I‘m struck by how many people seem to assume that a 60/40 consists of simply 60% in the S&P 500 Index and 40% in U.S. Treasury bonds or maybe domestic investment-grade issues more broadly. Yes, domestic mega-cap growth stocks (especially technology and tech-adjacent names such as Amazon and Tesla) have generated strong gains and could be considered overvalued. But other areas such as value, small-cap, and international stocks have largely been laggards, suggesting that a more diversified active approach might have brighter prospects looking forward if we see a change in market leadership.
Similarly, I agree that fixed income is not likely to benefit anytime soon from the massive tailwind of falling interest rates that we’ve experienced since 1981. However, attempting to predict even the direction of rates has proven to be very difficult, even for economists and other market professionals. It’s almost a cliché to opine that “rates have nowhere to go but up,” only to watch them decline further. Remember that bonds may still produce modest gains in an environment where rates stay low or rise only gradually. Also, spread product such as corporates, asset-backed securities, high yield, and emerging market debt offer the potential for higher income and appreciation relative to Treasurys. Finally, there may be room for active bond managers to add value through security selection, sector rotation, and yield-curve positioning.
Not-so-obvious reasons why the 60/40 is on its way out
Having said all of that, I suspect that there may be additional reasons underlying the concern about the 60/40’s prospects. It could be that some who are raising this issue have a stake in seeing investors expand their usage of less-traditional asset classes. If a plain-vanilla 60/40 looks less attractive from a risk/reward standpoint, maybe investors will shift their focus to REITs or commodities or private equity, just to name a few examples. And incorporating one or two of these investment types into a diversified portfolio would likely be advantageous to asset managers who specialize in them. Also, advisors who employ them could emphasize this as a point of differentiation, and possibly garner more appeal with end clients and prospects. Incidentally, I’m not saying that this is unethical or represents a conflict of interest. While that sometimes may be the case, it could also be true that managers and advisors who are advocating for these asset classes are actually doing investors a service by highlighting the diversification and performance-enhancing benefits of investments that they otherwise might not have considered.
Here’s another way of looking at the issue: these authors might, in a sense, be grieving the loss of an old reliable approach that served investors well for many years. To me, this is completely understandable. For a long time, the classic 60/40 represented a very effective investment solution that was elegant in its simplicity and easy to implement. Who wouldn’t be slightly melancholy in considering the possibility that the time has come to put it out to pasture? In a more pragmatic vein, if the 60/40 isn’t functional anymore, that means changes have to be made, client meetings must be scheduled, and work needs to be done to ensure that each client’s goals are being addressed by a more appropriate and suitable investment approach. Advisors might not be entirely thrilled about that burden, and all the potential paperwork.
But maybe we don’t have to think of the 60/40 in such a binary way. Maybe the 60/40 isn’t dead but simply stale and in need of a redesign. Given the economic and market turbulence we’ve experienced this year, this might be an opportune time to think about the possible benefits of greater diversification, additional asset classes, and active management. You might find the traditional 60/40 to actually be a pretty good starting point in constructing a portfolio for the next several years. And who knows, I might even find that those first few Van Halen albums are better than I realized.
There are risks involved with investing, including loss of principal. Current and future portfolio holdings are subject to risks as well. This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice. This information is for educational purposes only and should not be interpreted as legal opinion or advice.
Yield to maturity is the total return anticipated on a bond if the bond is held until it matures.
*Sources: fred.stlouisfed.org and Morningstar.com
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