Bond Selloff Highlights the Danger of a 60/40 Portfolio

Bond Selloff Highlights the Danger of a 60/40 Portfolio

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A journalist from Bloomberg contacted Dr. Laura Mattia last week to get her take on the 60/40 model. Read the article here:…. In the article, the journalist discusses that the 60/40 model has been underperforming most recently, and fixed-income’s wild week has reignited some concerns. Portfolios that held 60% stocks and 40% bonds fell 17% last year, their worst performance since 2008; today, they are still down 12% (having made up about 5%). (The Wall Street Journal claims 2022 was the worst year for the 60/40 model since 1937.)

In this video, we explain why people should diversify beyond a 60/40 portfolio if they want to manage risk. Press control and click on the photo below to watch the video, please “smash” the like button and make sure you subscribe to our channel!

The 60/40 rule is often considered outdated by many Ph.D. and CFA experts. While it still serves as a default investment strategy for those who may not fully grasp diversification. This rule advises investors to allocate 60% of their funds to stocks and 40% to bonds, but it may not take full advantage of the diverse investment options in the modern financial world. Investors are often attracted to the simplicity of the 60/40 rule. When we initially engage with a new client, many already hold a mix of U.S. stocks and bonds, frequently in the form of a 60% stock/40% bond portfolio.

However, it’s crucial to recognize that this strategy, at its core, only considers two asset classes, in contrast to the multi-asset class portfolio we typically recommend. Furthermore, it’s essential to acknowledge that the underlying risk remains concentrated in U.S. corporations. In essence, the portfolio is heavily exposed to a single type of risk. The question arises: where is the proper diversification in this approach?

The correlation between equities and bonds has shown a negative trend since the early 2000s, but it’s essential to recognize that this represents just the past two decades. When we take a broader historical perspective dating back to the 1870s, we see that the equity-bond relationship is far from static. Fan and Mitchel’s academic paper highlights the dynamic nature of equity-bond correlation cycles, which have experienced significant periods of both positive and negative correlations. Changing correlations underscores the notion that we should view their relationship as an evolving dynamic process.

The recent negative correlation regime from 2000 to 2010 was indeed unprecedented. Notably, June 2012 recorded the lowest one-year correlation at -91%, and March 2015 registered the lowest five-year correlation at -68%. Conversely, the highest one-year correlation was 88% in September 1983, and the highest five-year correlation was 56% in December 1986.

Since 2015, equity-bond correlations have been on the rise. While we could attempt to attribute this to fundamental factors like inflation expectations or expectations of tighter monetary policy, it’s essential to exercise caution when forecasting the future. Nevertheless, it wouldn’t be surprising if the equity-bond correlation remains positive for an extended period. It’s essential to acknowledge that while the 60/40 portfolio has performed well over the past 35+ years, it has primarily benefited from a period of declining interest rates. However, the financial landscape has evolved, and the tailwinds that once supported this strategy are no longer as favorable. Investors must adapt to this new reality and recognize that traditional methods may not yield the same results.

One critical concern with the 60/40 portfolio is its significant exposure to U.S. market securities, often exceeding 60%, exposing investors to unnecessary asset-concentration risk. Furthermore, the strong correlation between domestic stocks and bonds can amplify the consequences of relying heavily on domestic equities. It’s crucial to note that interest rates play a pivotal role in financial markets. By adding non-traditional asset classes to your portfolio, you can potentially reduce overall risk while maintaining or even enhancing returns. It’s essential to carefully consider your risk tolerance, investment goals, and time horizon when determining the appropriate allocation to non-traditional assets. Diversifying across various asset classes can help spread risk and increase the chances of achieving your financial objectives while minimizing exposure to any market or asset type. This approach aligns with the strategies employed by investment experts, foundations, and endowments seeking to optimize their investment portfolios.