Lewis Roxburgh – Trainee Investment Manager
The 60/40 portfolio, a portfolio consisting of 60% in stocks and 40% in bonds, has been a central principle of investing for decades. A mix in this way is claimed to lead to stock-market-like returns at a lower amount of risk. Yet with the prospect of lasting inflation and higher interest rates, this raises big questions as to the future of bonds and their place in a diversified portfolio. This has led me to investigate the past successes of the 60/40 portfolio and its viability as an allocation strategy for the future.
Figure 1: Real Return on £100 Invested from 1980-2021, using the MSCI Total Return Index (rebased) and UK 10 Yr Government Total Return Index (rebased). Inflation-adjusted using UK CPI. Source: DataStream, Calculations
I modelled a 60/40 portfolio going back to 1980. The portfolio returned 7.22% annually (assuming a perfect world of no taxes or costs), consistent with its objective of achieving a number higher than bonds but slightly lower than stocks. Over the last decade, the 60/40 portfolio actually outperformed an all-stock portfolio.
Modern Portfolio Theory, the investment equivalent of not putting all your eggs in one basket, tells us diversification is a great way to enhance the risk-reward trade-off. However, bonds were especially successful over the period for two reasons:
- Investors were rewarded for holding bonds as interest rates fell over the last 40 years (due to the inverse relationship between bond prices and yields).
- Bonds acted as a reliable counterweight to stock market crashes, as interest-rate cuts were associated with times of recession.
Both of these benefits no longer exist in the current climate. Interest rates in most major economies are either beginning to or are expected to rise, causing bond prices to fall.
The diversification benefit from holding bonds is also less clear, as persistently low interest rates have complicated the relationship between stocks and bonds. Since the Great Financial Crisis of 2008, correlations have been slightly positive, meaning that bonds and stocks go up and down together instead of protecting each other.
It is not all bad for bonds. The asset class still offers a lower risk investment that pays a fixed stream of income. As interest rates begin to normalise, investors should be able to earn a higher yield along with stronger diversification benefits, yet this is unlikely to happen soon.
In the meantime, investors may need to look to other asset classes for providing additional sources of diversification and yield in their portfolios. The 60/40 is not dead, but it can definitely be improved.