Q3 2021: Rethinking the 60/40 portfolio
Another three months are in the books, and returns during the third quarter look like a saw blade. There were some big headlines, like the crackdown in China, and another debt ceiling fueled government shutdown, but despite it all, June through September has been flat.
60% stocks and 40% bonds: the everyone portfolio
The quintessential portfolio is “The 60/40”. It’s a portfolio that consists of 60% stocks and 40% bonds, or more specifically, 60% S&P 500 and 40% 5-Year U.S. Treasury Bonds. While it’s evolved to include international stocks and corporate bonds, many still use it today in its original form. When we think about a benchmark portfolio, it is the 60/40.
The case for the 60/40 runs the gambit from being a policy portfolio to benchmark performance, to a portfolio investors actually own. It enjoys wide applicability. And in the last 40 years, the 60/40 has performed remarkably well.
One of the reasons that the 60/40 has done so well is that the 40% bond portion coincided with one of the best bond bull markets ever.
We’ve been in a bond bull market for 40 years
Returns for 5-Year US Treasury Bonds peaked in September 1981 at 16.27%. Since the peak, bond yields have dropped significantly, and sit at 0.98% today. Bond returns are inversely correlated to change in interest rates. As rates drop, bond returns go up. Since 1981, 5-Year US Treasury Bonds have returned 7.2% on average per year, but only 2.4% per year for the last 10 years. During this period, as rates have dropped, so have returns.
For reference, over the last 40 years (September 30, 1981 through September 30, 2021), the 60/40 has generated an average annual return of 10.5%, with a standard deviation of 11.4%. In any one year, you could have seen returns as high as 46.7% and as low as -26.6%. Since 1981, the 60/40’s worst ever showing was during the 2008-2009 crisis when the stalwart’s return was -29.93%, peak-to-trough.
And since the starting yield on your bonds tends to be a pretty good (not perfect) predictor of bond returns, it’s leaving many to wonder how to get returns out of bonds today.
Expected returns on the 60/40 are well below the historical record
According to Blackrock’s publicly available capital market assumptions, right now, US Treasury bonds are expected to return between -0.2% and 2.9% per year, for the next 10 years. Effects of inflation not included!
The 60/40 is expected to only return 4.35% per year for the next 10 years. That’s a far cry from its historical record. With so many still focused on the 60/40, the prospective returns may leave investors short on saving and investing goals, or force them to spend more principal than they’d like in retirement.
One way, and maybe the best way, to increase prospective returns, is to increase the risk of the portfolio. That could mean holding more stocks, or replacing bond investments with riskier alternatives like real estate.
We’d hate to forecast the death of the 60/40. Many have tried, and so far, none have succeeded. Continuing to run scenarios through the Blackrock tool, though, we’re starting to wonder if maybe 75/25 is the new 60/40.
Closing the expected return gap
Despite their safety, bonds are still volatile, meaning prices will fluctuate. Outside of inflation, cash does not fluctuate in value. A dollar is a dollar, and if held in an insured account, deposits are protected, up to $250,000 (FDIC guarantees up to $250,000 of total deposits by an individual at a given bank against bank failure). Second, while bonds add diversification benefits, cash is neutral. With interest rates so low, there is very little opportunity lost by holding cash instead of bonds.
To close the gap, and to try to earn the expected returns a financial plan calls for, we can slightly dial up the risk we take with stocks, while dialing down the risk we take with bonds. Moving the stock allocation to 75% and moving from bonds to cash, adds a little more risk, but also increases expected returns to 5.04%. This is a simple, but potentially effective solution.
Continuing with Blackrock’s tools, they suggest evolving the portfolio to include smaller cap stocks and bond alternatives, like long-short equity or global tactical allocation. While these additions increase expected returns and risk as intended, they also add complexity.
More return requires more risk. There just isn’t anything that can provide high returns with no risk. Options are available to close the expected return, they just all require more risk.
Adjusting portfolios to meet long-term goals
The consensus is clear: expect lower returns across all asset classes over the next 3, 5, 7, and 10-year periods. Track records have never been a good proxy for future performance. Remember, past performance does not forecast future performance. That is truer today than ever before, with the bond portion of every balanced portfolio earning ultra-low yields.
Portfolios are being adjusted in the face of this reality to include more stocks, small cap stocks, international stocks, and even Chinese stocks. Given current forecasts, which are very uncertain, it looks like more risk is required to earn higher returns. There will still be balance, but the 60/40 of yesteryear needs some tweaks to prevent coming up short on goals.
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Adam K. Wright, CFA, CFP®
Adam guides the vision and implementation of the firm's fiduciary service approach and directs our client engagement, service integration and investment management practices.
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