There are two main alternatives to 60/40. One is to use equities as a benchmark and treat bonds as just another asset class for diversification — like commodities, real estate, venture capital, alternative strategies and private investments. The other is to jettison the idea of a core portfolio and allocate assets based on some other principle, such as risk parity, Black-Litterman or Markowitz optimization.
A major flaw in the BlackRock analysis is to ignore valuation. Based on cyclically adjusted price-to-earnings, or CAPE, ratios for stocks, and interest rates for bonds, the attractiveness of 60/40 has been falling steadily since 2008. At the beginning of 2022, 60/40 investors were facing an exceptionally high 38.3 CAPE for the S&P 500 Index and a low 1.4% yield for 10-year Treasury notes. Actual inflation was 7%, but the market was pricing in future inflation of just 2.5%. When you buy expensive stocks and low-yielding bonds in a high-inflation environment, you can’t be completely surprised by a bad result.
Strategy Failure | Putting 60% of your money in stocks and 40% in bonds was supposed to support portfolios
Today, CAPE has fallen to a more moderate level of 28 and the 10-year Treasury yield is up to 3.5%. Inflation has slowed only slightly, to 6.5%, but the Federal Reserve seems much more determined to get it under control than in the beginning of 2022. Investors who flee 60/40 based on a bad 2022 may be making the classic mistake of selling at the bottom. It’s still less attractive than historically, but it’s expected real return is considerably higher than it was for 2022.
BlackRock did not rely solely on dismal 2022 performance and the reduced diversification value of bonds since 2015 for its call. One of the economic arguments for 60/40 is that the phase of the business cycle that causes stock prices to fall tend to bring lower interest rates, which help bonds. In addition to the natural relation between the markets, the Fed is apt to raise interest rates when stocks are going up, and cut them when stocks are going down, reinforcing the diversification value of bonds. This argument seemed strong during the Great Moderation that began in 1983 and ended in 2014.
See also: Tariffs,Trump and AI are changing everything. Should my portfolio change too?
But 2022 looked like a return to an earlier period in which inflation savaged both stock and bond returns, and the Fed seemed unable or unwilling to combat budding inflation. If you believe this to represent the future — an ineffectual Fed pushing up interest rates but failing to contain inflation, and that inflation along with other negative forces preventing robust economic growth — then 60/40 may be a volatile portfolio with weak returns after inflation. War, uncontrolled deficits, political disfunction, possible US government default sound more like the 1970s than what we have been used to since.
If there has been a regime shift in which stocks and bond are more likely to move together than in opposite directions, and inflation proves hard to kill, and investments respond more to war and politics than constructive economic activity, all core portfolios are endangered. But this sounds more to me like the PTSD of investors battered by a terrible year following a global pandemic than a sober assessment of the future.
I think 60/40 is alive and well. It’s no guarantee of financial success, but nothing is. The world of 2023 and beyond may be more chaotic than the Great Moderation, but that’s all the more reason to have a steady benchmark. Investors might want to dial the risk down a bit, say to 50/50, and put larger allocations into alternatives, but a long-term core allocation among the two most fundamental asset classes — with the most liquidity and lowest costs — remains a good idea.
