How inflation and rate hikes affect the 60/40 portfolio strategy

How a 60/40 portfolio strategy works

The strategy invests 60% in equities and 40% in bonds – a traditional portfolio that carries moderate risk.

More broadly, “60/40” is an acronym for the broader theme of asset diversification. The idea is that when stocks (the growth engine of a portfolio) underperform, bonds serve as deadweight, as they often don’t move in lockstep.

The classic 60/40 mix includes US equities and investment-grade credit (like US Treasuries and high-quality corporate bonds), said Amy Arnott, portfolio strategist at Morningstar.

Market conditions have emphasized the 60/40 mix

Until recently, the combination was hard to beat. According to a recent analysis by Arnott, investors with a basic 60/40 mix achieved higher returns than investors with more complex strategies in each subsequent three-year period from mid-2009 to December 2021.

Low interest rates and below-average inflation boosted stocks and bonds. But market conditions have fundamentally changed: interest rates are rising and inflation is at a 40-year high.

US stocks have responded by plunging into a bear market, while bonds have also fallen on a scale not seen in many years.

As a result, the 60/40 portfolio is struggling: It’s down 17.6% this year through June 22, according to Arnott.

If sustained, that performance would only lag behind two Depression-era downturns in 1931 and 1937, which saw losses in excess of 20%, according to an analysis of historical 60/40 annual returns by Ben Carlson, MD Director for institutional asset management at Ritholtz Vermögensverwaltung.

“There is still no better alternative”

Of course the year is not over yet; and it’s impossible to predict if (and how) things will get better or worse from here.

And the list of other good options is thin at a time when most asset classes are coming under pressure, according to financial advisors.

If you’re in cash right now, you’re losing 8.5% a year.

Jeffrey Levin

Chief Planning Officer at Buckingham Wealth Partners

“Well, so you think the 60/40 portfolio is dead,” said Jeffrey Levine, CFP and chief planning officer at Buckingham Wealth Partners. “If you’re a long-term investor, what else are you going to do with your money?

“If you’re in cash right now, you’re losing 8.5% a year,” he added.

“There’s still no better alternative,” said Levine, who lives in St. Louis. “When presented with a list of uncomfortable options, choose the least uncomfortable.”

Investors may need to recalibrate their approach

While the 60/40 portfolio may not be outdated, experts say investors may need to recalibrate their approach.

“It’s not just the 60/40, it’s what’s in the 60/40,” Levine said.

But first, investors should reconsider their overall asset allocation. Maybe 60/40 – a mediocre, not overly conservative or aggressive strategy – isn’t for you.

Determining the right one depends on many factors alternating between the emotional and the mathematical, such as: B. Your financial goals, when you want to retire, life expectancy, your comfort with volatility, how much you want to spend in retirement, and your willingness to pull back on that spending if the market goes haywire, Levine said.

Although bonds have performed similarly to stocks this year, it would be unwise for investors to dump them, Morningstar’s Arnott said. Bonds “still have some significant benefits for risk mitigation,” she said.

The correlation of bonds to stocks rose to about 0.6% over the past year — still relatively low compared to other stock asset classes, Arnott said. (A correlation of 1 means the assets track each other, while zero means there is no relationship, and negative correlation means they move in opposite directions.)

According to research from Vanguard, since 2000 their average correlation has been largely negative.

The S&P 500 Index is down 21% in 2022 and the Bloomberg US Aggregate Bond Index is down 11%.

“It will probably work over the long term,” Roth said of the diversification benefits of bonds. “High-quality bonds are much less volatile than stocks.”

Diversification “is like an insurance policy”

The current market has also shown the value of broader investment diversification within the equity-bond mix, Arnott said.

For example, the added diversification within stock and bond categories on a 60/40 strategy resulted in an overall loss of about 13.9% this year through June 22, an improvement from the 17.6% loss over the classic version with US equities and investment grade bonds. to Arnott.

(Arnott’s more diversified test portfolio allocated 20% each to US large-cap stocks and investment-grade bonds; 10% each to developed and emerging market stocks, global bonds and high-yield bonds, and 5% each to small-cap stocks, commodities, gold and real estate funds.)

“We didn’t see them [diversification] Benefits for years,” she said.

“But if it is, you’re probably glad you had it,” Arnott added.

Investors looking for a hands-on approach can use a target date fund, Arnott said. Money managers maintain diversified portfolios that automatically rebalance and reduce risk over time. Investors should hold these in tax-advantaged retirement accounts rather than taxable brokerage accounts, Arnott said.

A balanced fund would also work well, but asset allocations remain static over time.

Do-it-yourselfers should make sure they’re geographically diversified when it comes to stocks (beyond the US), according to financial advisors. They may also want to favor ‘value’ rather than ‘growth’ stocks as company fundamentals are important in challenging cycles.

Compared to bonds, investors should prefer short and intermediate-dated bonds to longer-dated bonds in order to reduce the risk associated with rising interest rates. You should probably avoid so-called “junk” bonds, which behave more like stocks, Roth said. I-Bonds offer a safe hedge against inflation, although investors can generally only buy up to $10,000 a year. Inflation-linked government bonds also offer protection against inflation.

Leave a Comment