With stocks and bonds now falling at the same time, the question has arisen as to whether the 60-40 portfolio still makes sense.
Of course, 60-40 refers to a 60% stock weighting and a 40% bond weighting. As for market movements, the S&P 500 stock index has slumped 18% so far this year amid roaring inflation and interest rate increases by the Federal Reserve. Meanwhile, the Bloomberg U.S. Aggregate bond index has slid 10%.
But the 60-40 portfolio isn’t dead, says Roger Aliaga-Díaz, Vanguard’s chief economist for the Americas.
“Brief, simultaneous declines in stocks and bonds are not unusual,” he wrote in a commentary. “Viewed monthly since early 1976, the nominal total returns of both U.S. stocks and investment-grade bonds have been negative nearly 15% of the time.”
But that’s only part of the story. “Extend the time horizon, and joint declines have struck less frequently,” Aliaga-Diaz said. “Over the last 46 years, investors never encountered a three-year span of losses in both asset classes.”
60-40 Performance
Still, slides in 60-40 portfolios have occurred more regularly than simultaneous declines in stocks and bonds. “This is due to the far-higher volatility of stocks and their greater weight in that asset mix,” he said.
“One-month total returns were negative one-third of the time over the last 46 years. The one-year returns of such portfolios were negative about 14% of the time, or once every seven years, on average.”
But the picture still looks bright for the 60-40 portfolio Aliaga-Diaz said. “The goal of the 60-40 portfolio is to achieve long-term annualized returns of roughly 7%,” he said. “This is meant to be achieved over time and on average, not each and every year.”
The annualized return of a 60-40 portfolio from 1926 through 2021 was 8.8%. And going forward, Vanguard forecasts the long-term average return will be around 7%.
Of course, that doesn’t imply it will always be smooth sailing, Aliaga-Diaz said.
“Market volatility means diversified portfolio returns will always remain uneven, comprising periods of higher or lower—and, yes, even negative—returns.”
From Positive to Negative and Vice Versa
Moreover, the math of average returns suggests strong performance by the 60-40 portfolio should follow weak performance and vice versa.
“The average return we expect can still be achieved if periods of negative returns (like this year) follow periods of high returns,” Aliaga-Diaz said.
And indeed, “during 2019–2021, a 60-40 portfolio delivered an annualized 14.3% return, so losses of up to 12% for all of 2022 would just bring the four-year annualized return to 7%, back in line with historical norms.”
Meanwhile, “the math of average returns suggests that periods of negative returns must be followed by years with higher-than-average returns.”
Vanguard estimates the 10-year annualized average return outlook for the 60-40 portfolio is now higher by 1.3 percentage points than it was before the downward moves in stocks and bonds this year.
Aliaga-Diaz says nothing about the 60-40 portfolio is "magical." But “in our view, 60-40 is a sound benchmark for an investment strategy designed to pursue moderate growth,” he said.
“The broader, more important issue is the effectiveness of a diversified portfolio, balanced across asset classes, in keeping with the investor’s risk tolerance and time horizon.”
