A 60/40 portfolio – allocating 60 per cent into stocks and 40 per cent into bonds – seeks to balance the higher risk and higher return potential of stocks with the lower risk and stability of bonds.
Such a portfolio holds out the chance of achieving higher risk-adjusted returns over time than a portfolio invested in stocks alone, and can be a good compromise between growth and stability for long-term investors.
Due to their low volatility and historically low correlation with stocks, bonds are traditionally seen as the best option to diversify and protect against the downside risk of stocks. During the financial crisis of 2007-2008 and the dotcom bust of 2000, bonds did indeed provide a cushion against equity losses as central banks moved to offset market turmoil by cutting interest rates.
As for stocks, the S&P 500 has experienced falls of greater than 5 per cent on 83 occasions since 1870. On 74 of these, 10-year US Treasuries posted positive returns over the same period. On average, the S&P 500 has declined by about 15 per cent in each peak-to-trough cycle since 1870.
Since Treasuries have risen by an average of 3 per cent over the same period, a 60/40 US portfolio would have fallen by an average of 8 per cent, much less than an equity-only portfolio.
2022 was the only time when bonds did not provide protection against an equity market sell-off of greater than 20 per cent. Last year, the S&P 500 index fell by 24 per cent and US 10-year Treasuries lost 17 per cent. Central banks’ aggressive tightening of monetary policy to curb inflation took its toll on stocks and bonds alike. As bonds failed to mitigate stock losses, a 60/40 US portfolio would have fallen about 21 per cent, its worst performance since the global financial crisis.
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This year, government bonds again appear to be playing their role as a buffer for equities amid severe stress in the banking sector. Notably, there has been a huge inflow into money market funds during the US banking crisis. The source of stress was not recession fears but banking crisis fears.
In response to this stress, central banks are expected to accord heightened importance to preserving financial stability. As a result of the events in the banking industry, bond yields have come down and bond prices have risen. Inflation has now declined as we expected, mostly due to favourable base effects. The decline will continue through year-end but will likely fail to get back to the Fed’s targeted 2 per cent, as the labour market remains tight and energy prices are rebounding.
A 60/40 strategy is evidently driven more by equity cycles than by bonds, which provide fixed coupons. Bonds generally reduce a portfolio’s volatility, serving as a cushion for equity losses during market turmoil. A 60/40 portfolio should usually experience lower losses than an equities-only portfolio over the short term, with the strategy looking even more attractive in the long term. Recoveries in the performance of 60/40 portfolios have always outstripped previous drawdowns and have always lasted longer.
Based on monthly data, the average annual return from a 60/40 portfolio over a 10-year period has been around 8 per cent since 1870, while the first quartile and median returns have been 5.4 per cent and 7.2 per cent, respectively.
This means that investors have a 50 per cent chance of achieving an annual return of 7.2 per cent over a 10-year period, and a 75 per cent probability of a return of at least 5.4 per cent.
The average volatility is substantially lower for a 60/40 portfolio than equities alone. The average volatility of the S&P 500 since 1870 has been around 15 per cent, while for a 60/40 US portfolio, it has been 9 per cent. The latter has provided a risk-adjusted return ratio of around 0.85 since 1870, compared with 0.61 for the S&P 500.
Our expectation for average real gross domestic product (GDP) growth in the US of 1.9 per cent over the next 10 years remains practically unchanged from our earlier forecast of 2 per cent. However, we have increased our forecast for global real GDP growth from 2.8 per cent to 3.2 per cent.
We expect the headline consumer price index to post an annual average of 2.7 per cent over the next 10 years – lower than our forecast in 2022, but higher than actual inflation over the past 10 years. Inflation has a negative impact on bond returns and weighs on the positive correlation between stocks and bonds.
On the other hand, interest rates are also expected to be elevated over the next decade, with the yield on 10-year US Treasuries averaging 4.3 per cent.
Despite the expected increase in inflation, the macroeconomic backdrop should stay favourable for 60/40 portfolios over the coming decade. Bond yields are expected to remain higher than in the past. This suggests bonds will once again be a viable source of positive real income and a potential buffer against downside risk in equities.
High interest rates mean central banks will have more room to cut in the event of a recession or crisis. And equities are also looking more attractive compared with last year due to the fall in valuations.
The combination of these two factors means that markets could potentially offer better long-term returns over the next decade than we forecast last year.
In short, we see a rise in average annual returns from both components of a 60/40 portfolio over the next decade, compared with our expectations over the past two years.
At an expected annual average return of 5.2 per cent, our projections for a 60/40 US portfolio are the highest since 2015, while we expect a global 60/40 portfolio (60 per cent MSCI AC World, 40 per cent global Treasury) to achieve an annual average return of 5.3 per cent over the next decade.
The writer is head of CIO office and macro research, Pictet Wealth Management
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