The 60/40 is Dead. Long live the 60/40!
2022 has been a bruising year for most balanced portfolios. A typical 60/40 stock/bond portfolio saw a drawdown of -16% from December through the end of June. This feels especially disappointing when you consider that the S&P 500 was down only slightly more than that over that same period. Where’s the defense?
The biggest issue has been an outright failure of bonds to provide any meaningful downside protection while stocks were slipping. While unusual in recent times, this is not a fluke. Bonds are only reliably diversifying versus stocks in times of relatively low inflation. In contrast, high or rapidly escalating inflation, caused in part by outside forces (think Ukraine & COVID) can motivate the Federal Reserve to raise interest rates even if the economy is slowing and corporate earnings growth is decelerating. When that happens, it’s a set up for both stocks and bonds to drop in tandem.
There has been some well justified hand-wringing about whether this ‘failure’ of bond/equity diversification implies a need for a structural change in how balanced portfolios are put together. Perhaps more liquid alternatives, real assets or short-term bonds are the solution?
Yes, and no. All of these asset classes have a place in a well-rounded portfolio. For very risk averse investors, they should be considered core food groups. However, they come with drawbacks and will usually tend to reduce the long-term rate of return in portfolios. Not something to take lightly if you have a long-term investment horizon.
Equally, there is a case to be made for not overreacting to recent experience. Central banks have every tool they need to get inflation back down to earth, and it’s likely that one day soon, bonds will resume their role as an effective diversifier and risk-dampener in portfolios. Rapidly rising interest rates are already setting the stage for that to happen.
Rather than throw the baby out with the bathwater, it’s more sensible to simply revisit the way the average balanced portfolio is managed. Many advisers today rely on portfolios with relatively static equity/bond ratios, re-balancing from time to time, but otherwise adopting an attitude of benign neglect. While there are positive things to say about this approach, it tends to leave your clients’ portfolios exposed to surprising levels of downside from time to time. A portfolio that maintains a single, unvarying level of risk is a bit like having only one outfit to wear, no matter the season. It’s going to be uncomfortable at least half the time.
For advisers who want to inject a bit of active risk management into their investment process, there are two relatively simple steps that can be taken in an attempt to mitigate draw-downs like those seen in the first half of 2022.
Vary your portfolio’s overall risk stance over time based on valuation trends. Stretched (high) valuations certainly don’t always precipitate difficult market conditions. But high asset prices exacerbate the impact of any negative catalyst, including rapidly accelerating inflation and interest rates. Moreover, while it can be difficult to anticipate bursts of inflation far in advance, it’s often very clear when valuations are too high. Consider incrementally stepping down your exposure to stocks when price multiples are reaching extreme highs and decreasing your exposure to bonds when yields are reaching extreme lows. Doing this in an incremental and systematic fashion will tend to result in a portfolio that’s been ‘de-risked’ by the time the Fed takes away the proverbial punch bowl.
Build a playbook and lay a foundation for next time. We’re probably past peak inflation right now. But when you next perceive the risk of inflation to be rising, you may want to consider allocating to TIPS, commodities, select forms of liquid real estate, resource and consumer-staple stocks. All of these are available in relatively low-cost mutual fund and ETF formats today. Once inflation has begun to moderate and prices for these assets decline, consider having a small foundational (or structural) allocation to at least a few of these. In that way you’ll have a ‘lever’ you can pull on short notice, the next time we face similar circumstances. It’s much easier (procedurally and psychologically) to increase an existing allocation at short notice than it is to research and due-diligence entirely new instruments and asset classes. Develop similar contingencies for other scenarios, like deflation/deep recession.
In summary, the 60/40 portfolio is not dead. Bonds and stocks are likely to play nicely together again once inflation shows signs of being tamed. The weakness of balanced portfolios in 2022 is not a sign of structural problems. If anything, it’s a symptom of over-reliance on static portfolio design. Equity-bond allocation ratios are no more a strategy than a foundation is a house. Let’s get building!