Rethinking the 60/40 portfolio
Morgan Stanley Wealth Management09/08/22
Summary: The classic portfolio of 60% stocks and 40% bonds may no longer provide the same level of returns it has delivered previously, but it may still be right for some investors. Here’s why.
From the 1980s until recently, a portfolio of 60% stocks and 40% bonds experienced a “golden age”—and for a good reason. The mix consistently provided investors with attractive risk-adjusted returns, with total returns often equal to or better than those of the S&P 500® Index, and with lower volatility.
But this strategy may no longer pack the same punch. Persistent inflation and growing recession fears have battered markets in 2022, providing strong headwinds to the 60/40 portfolio and prompting some critics to proclaim “the end” of the 60/40 as a useful investment strategy.
However, even if the 60/40 portfolio is poised to deliver lower risk-adjusted returns compared with those over the last four decades, that doesn’t mean it is “broken.” Morgan Stanley & Co. recently forecast a 10-year return of about 6.2% per year for the strategy, which is 3.9 percentage points above their forecast for inflation.1 Indeed, the 60/40 may remain attractive for some investors, even as others look to different strategies.
To determine the future of the 60/40 portfolio, it is important to understand:
- What drove the 60/40 portfolio’s stretch of relatively strong performance over the past four decades?
- Why does this remarkable success seem unlikely to persist at the same level going forward?
- How can investors pivot for the future?
Secrets to success
The 60/40 portfolio owes much of its past success to three key factors:
- Slowing inflation. In the early 1980s, the Federal Reserve managed to stamp out high inflation from the prior decade, and with that came falling Treasury yields and lower correlations between stocks and bonds. This helped to provide portfolio diversification and healthy total returns for both asset classes.
- Falling real yields. Yields tend to move inversely with asset prices. As inflation-adjusted, or “real,” yields gradually fell over the past four decades, stocks and bonds tended to benefit, as companies enjoyed lower costs of capital and higher valuations for financial assets.
- An accommodative Federal Reserve. Investors grew increasingly confident they could rely on a “Fed put”—central bank intervention aimed at ensuring liquidity in the financial system and containing market volatility. These actions led markets to believe the Fed would step in to limit damage during times of uncertainty.
A bumpy road ahead?
Those favorable conditions are likely to fade, however, given the following:
- Normalizing inflation. Higher inflation levels could lead to a higher, positive correlation between stocks and bonds, which would reduce the potential diversification benefits of a stock-bond mix.
- Low but rising real yields. Real yields are likely to rise along with inflation, which would pressure bond prices and make stocks less attractive, likely leading to lower returns from the 60/40 portfolio.
- A less hands-on Fed. The Fed may be less willing and able to intervene in moments of market turbulence, removing a key support for asset prices.
How investors can prepare
Bottom line, investors should reset expectations for what the classic 60/40 portfolio may return in the years ahead. While it may still deliver solid performance, returns are likely to be less than the last 40 years. Instead of taking on more risk to make up for potential shortfalls, consider thoughtful strategies.
Tax-efficient investing can help increase after-tax returns, whether through tax-loss harvesting or using realized losses to help offset capital gains for tax purposes.
A mix of active and passive investing may also be beneficial. Many investors prefer either passive strategies, which track an index, or active strategies, which attempt to outperform the index, but the two aren't mutually exclusive.
Finally, liquid alternative funds may help further diversify a portfolio and potentially enhance its risk-adjusted performance. For example:
- Absolute return: Funds following equity market neutral and relative value arbitrage strategies seek to earn a positive return over time—regardless of whether markets are going up, down, or sideways—and to do so with less volatility than stocks.
- Equity hedge: Macro trading and multi-strategy funds implement strategies with the goal of providing equity-like returns while limiting the impact of market downturns and volatility.
- Equity return: Long-short equity and event-driven strategies aim to deliver attractive risk-adjusted returns in equity or corporate credit securities.
To be sure, a 60/40 allocation may continue to work for some investors. Bonds likely remain good diversifiers for stocks, helping to dampen the effects of volatility, even if they don’t offer the same degree of diversification as they did before. Ultimately, investors should make sure they are staying true to their goals, timelines, and risk tolerance when considering how they are positioning portfolios for the path ahead.
The source of this article, Rethinking the 60/40 Portfolio, was originally published on August 30, 2022. Data based on Morgan Stanley Wealth Management’s Global Investment Committee report, “Sunset for 60/40?: Assessing Its Long-Term Success, Its Recent Struggles and Some Potential Pivots” (June 7, 2022).
- Morgan Stanley Research, “60:40 Isn’t Dead, Just Resting,” 7/24/22
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