- The 60/40 portfolio is a traditional investment strategy that consists of 60% stocks and 40% bonds.
- The effectiveness of the 60/40 portfolio has been called into question due to factors including high inflation, changes in the correlation between stocks and bonds, and a lack of downside protection.
- This article examines the 60/40 investment approach and explores ways in which it can be modified to achieve better diversification for long-term portfolios.
The 60/40 portfolio is a traditional investment strategy that aims to provide a balanced mix of stocks and bonds to help reduce risk and generate long-term returns. It’s called a 60/40 portfolio because it typically consists of 60% stocks and 40% bonds.
Stocks are considered to be riskier investments because they’re subject to market fluctuations and tend to have greater volatility. However, they also have the potential to provide higher returns over the long term. Bonds, on the other hand, are considered to be safer investments because they provide a fixed income stream and are generally less volatile. The 60/40 portfolio is based on the idea that stocks will provide growth, while bonds will provide stability and income. By combining the two asset classes, investors can potentially achieve a more balanced portfolio that reduces the overall volatility of their investments.
This has been a popular investment strategy for many years, and is often recommended by financial advisors as a way to diversify and manage risk. However, the current market environment is showing investors that this type of portfolio is not a one-size-fits-all solution, and should not be considered an “all-weather” approach. In this article we’ll review why the 60/40 portfolio has become popular over time, dive deeper into the reasons behind the shortcomings of the strategy and discuss ways in which this investment approach can be modified to achieve better diversification for long-term portfolios.
Why the 60/40 portfolio became popular
It’s not hard to see why the 60/40 portfolio has become popular as it can appeal to investors who are seeking a mix of growth and income. This is especially so considering the investment approach has benefited from a long-term bullish trend in both stocks and bonds. Over the past few decades, both asset classes have performed considerably well, with non-threatening levels of inflation and consistently accommodative interest rates.
It also helps that passive investment vehicles, such as ETFs, have made the 60/40 approach far easier and more cost-efficient to maintain. Implementing this investment strategy is relatively straightforward and can be done with a minimum level of effort. Just a few line items can give investors exposure to hundreds or even thousands of underlying assets. This makes it an attractive option for investors who are looking for an easy and efficient way to invest.
Why the 60/40 portfolio is no longer as effective
The effectiveness of the 60/40 portfolio has come into question in recent years due to a number of factors, including high inflation, changes in the correlation between stocks and bonds, and a lack of downside protection.
While the mix of stocks and bonds may provide a balanced portfolio under certain market environments, investors are nonetheless concentrating their exposure to just two asset classes which may not provide enough diversification to protect against shifts in the economy. In the context of today’s market, for example, bonds are typically not considered to be a good hedge against inflation.
This is a particularly shocking dynamic for investors that have become accustomed to a negative correlation between stocks and bonds. Meaning that when one asset class performed poorly, the other tended to perform well. This negative correlation helped to balance out the ups and downs of the market, providing investors with more predictable returns. However, recent market risks and headwinds have affected stocks and bonds in the same way, meaning that they both declined. This change in correlation has resulted in the worst year for the 60/40 portfolio in 100 years[i].
This highlights a deeper problem: the lack of protection against potential market drawdowns. Unlike actively managed funds, which are run by professional managers who try to outperform the market, passive investments like the 60/40 portfolio are simply invested in the underlying markets. So, while actively managed funds may try to minimise losses during market drawdowns by moving money out of stocks and into cash or other safe assets, passive investments do not have this ability. Instead, they simply track the market and are therefore subject to the same losses as the overall market. This lack of downside protection can be a major concern for investors who are looking to preserve their wealth during times of market volatility.
The unspoken risk of the 60/40 portfolio
Because 60/40 portfolios are concentrated in two assets, some investors may be tempted to compensate for it by spreading their investment within each asset class across a large number of companies. Rather than achieving diversification, this can actually lead to a dilution of performance and erosion of returns.
One of the main reasons why investors may be tempted to spread their investments too thinly is that they believe that diversification is always a good thing. While it is true that diversification can help to reduce risk by spreading investments across different asset classes and industries, it is also possible to have too much diversification. The misguided practice of over-diversification ignores the fact that investing in a large number of companies can actually lead to erosion of returns. When an investor spreads their investments too thinly, the individual investments in the portfolio may not be large enough to have a meaningful impact on overall returns. Meanwhile, it is possible that many of those companies may be in the same industry or sector. So, if that industry or sector experiences a downturn, the investor’s entire portfolio may still be affected, leading to significant losses.
This topic is addressed in Modern Portfolio Theory (MPT). Model portfolio theory was developed by Nobel Prize-winning economist Harry Markowitz and is used by investors and financial advisors to determine the optimal mix of investments for a given portfolio. The idea behind MPT is that while investors need to diversify their investments in order to manage risk, there is a point of diminishing returns when it comes to the degree of diversification. As an investor adds more and more stocks to their portfolio, the additional diversification benefits become less and less significant. In fact, a portfolio with as few as 20-30 stocks may provide the best balance between diversification and returns. Going beyond this level may risk dilution of returns which can lead to suboptimal performance.
The 60/40 approach creates a natural reliance on spreading the portfolio across many companies that are ultimately likely to behave similarly during market turmoil. To modify portfolios, investors should seek true diversification across differentiated asset classes and strategies.
A better path to achieving diversification
How can investors look to achieve better diversification in their portfolios without sacrificing potential returns? As an asset class, liquid alternative investments have a wide range of opportunities, many of which can provide diversification via low correlation with major stock and bond markets.
In a previous article titled Liquid Alternative Investment Strategies That Can Help You Navigate Market Uncertainty, we spoke about quantitative and systematic investment strategies and how they can help navigate portfolios through periods of market turmoil by targeting differentiated sources of absolute returns. This means, they seek to identify and exploit specific patterns and market dynamics that tend to be independent not just of broad market behaviour but also of each other.
It’s also worth reiterating that some quantitative investment strategies can offer investors greater control over portfolio drawdowns and volatility. Because of the systematic nature of these strategies, many of the risk parameters are set in advance and implemented automatically. This can provide an added layer of comfort for investors.
The 60/40 portfolio, a traditional investment strategy that consists of 60% stocks and 40% bonds, has become less effective in recent years due to high inflation, changes in the correlation between stocks and bonds, and a lack of downside protection. With the shortcomings of the 60/40 model coming to light, it is worth exploring opportunities in the liquid alternative investment space as a way to modify investment portfolios and achieve better diversification.
Disclaimer – FundFront Ltd., does not provide advice and the information in this article should not be construed as such. FundFront Ltd., is registered in England and Wales, and its Registered Office is at C/O Zeeta House, 200 Upper Richmond Road, London, United Kingdom, SW15 2SH. Company Number: 13711456. FundFront Ltd., is an Appointed Representative of Brooklands Fund Management Limited, which is authorised and regulated by the Financial Conduct Authority with the firm reference number 757575 and the Securities and Exchange Commission with the registered number 286221.
[i] BofA Global Investment Strategy, Global Financial Data, 2022 is YTD annualised