Is it Time to Revisit the 60/40 Portfolio?

The 60/40 portfolio combines the growth potential of stocks, with the relative stability of bonds. Is this conservative approach still valid?

A popular investment mix is the 60/40 portfolio, which combines the growth potential of stocks, with the relative stability of bonds. In an era of high-interest rates and high-growth tech stocks, is this conservative approach still valid?

As far as investment portfolios go, the 60/40 portfolio is perhaps the most well-known. It is a simple and elegant mix that was widely promoted as a conservative and stable way to reap market returns.

This style of portfolio management was especially popular during the 80s and 90s. However, with the changing economic landscape marked by high-growth tech stocks and high inflation, many investors abandoned the 60/40 approach in favour of alternative portfolio management strategies.

Let’s find out how the 60/40 portfolio works, and whether it still holds any merit today.

Understanding the 60/40 portfolio

In short, the 60/40 portfolio simply means having 60% of your investment portfolio in stocks, and 40% in bonds. As you continue to invest more, you’d make adjustments to maintain this balance within your portfolio.

Why this mix, and not, say, 70/30, or 80/20? And why only stocks and bonds in particular? Well, at the time, the 60/40 portfolio was considered to offer the best balance between growth and resilience, primarily due to the relationship between stocks and bonds.

The inverse correlation between stocks and bonds

It is observed that when the stock market is bearish, and share prices are falling, investors tend to sell off their shares and buy into bonds instead.

This is because bonds – which are debt instruments issued by governments and corporations, and pay out a fixed coupon amount each year – are seen as a less risky way to continue earning a return during a downturn.

However, the influx of capital into the bond market drives up demand, which causes bond prices to go up. Correspondingly, when bond prices go up, bond yields go down.

This is because the yield on a bond is calculated by dividing the annual coupon payment by the price of the bond.

Here’s an example:

Bear in mind that once issued, a bond’s annual coupon payment does not change – in our example, it remains at S$50 per year, or 5%.

When the price of the bond increases, the annual coupon payment still stays at S$50 per year. But the resulting bond yield falls to 4.16%.

Thus, bond yield falls further as demand increases, until investors feel the yield is too low to be worth it. At this point, investors start channelling their funds back to the stock market, bringing down bond prices and allowing bond yields to rise again.

This is, of course, just a very simplified example, and real life market conditions are much more dynamic and convoluted.

But for our purposes, we just need to understand the inverse correlation between stocks and bonds, as that is the basis for why the 60/40 portfolio was readily recommended during its heyday.

The 60/40 portfolio – balance and diversification

Ok, so the overarching idea is that capital moves from stocks to bonds during a downturn, and moves back to stocks when bond yields become compressed beyond a certain point.

Based on that, the 60/40 portfolio is designed to offer balance between risk and returns, combining the potential capital appreciation of stocks, with the relative stability of bonds.

During a bullish stock market, investors can enjoy portfolio growth from the rise in the prices of shares they hold. During a bearish phase, investors can benefit from higher bond prices, while still continuing to collect coupon payments.

Thus, this formula puts investors at an advantage no matter which way the market goes, and over the long run, provides favourable investment results.

Indeed, asset manager Charles Schwab has demonstrated that in an investment period tracking 1976 to 2023, the 60/40 portfolio is more than capable of keeping pace with all-stock or all-bond portfolios.

Source

Another oft-cited benefit of the 60/40 portfolio is diversification, thanks to the involvement of two different (and inversely correlated) asset classes.

Is the 60/40 portfolio the best portfolio today?

The 60/40 portfolio is a capable strategy over the long term, but it is not without its weaknesses.

One such drawback is periods of low bond prices – which occurs when interest rates are high. This will negatively impact the overall value of a 60/40 portfolio, more so than a portfolio with a smaller bond allocation.

Investors should also not be lulled into a false sense of security just because they are invested in two different asset classes. They should ensure a healthy level of diversification among the actual stocks and bonds they hold.

For instance, holding mainly tech or AI startup stocks will expose you to higher volatility than if you were to choose, say the S&P 500 or a collection of stocks from different, unrelated sectors instead.

At the end of the day, it’s important to realise that there is no one-size-fits-all solution when it comes to portfolio management.

While the 60/40 portfolio is as good a starting point as any, investors should ultimately adjust their portfolio allocation according to their individual objectives, preferences and investing timelines.