After rough ride in '22, 60/40 portfolio looks poised for solid '23

While there might not be a lot of investors or financial advisors strictly adhering to the classic portfolio model of 60% stocks and 40% bonds, it still represents a proxy for a generally safe and mundane strategy that's supposed to keep investors out of trouble.

That didn’t happen in 2022, a rare year in which both stocks and bonds fell, leading to a 14.3% decline for the 60/40 model and potentially raising doubts about the future of mundane portfolio allocations.

“This is likely going to cause advisors to seek out some alternatives exposure to ETFs like [managed futures] or commodities like gold to provide a counterbalance in 2023,” said Todd Rosenbluth, head of research at VettaFi.

Using the Vanguard Wellington Fund (VWELX) as a proxy, it was the worst year for 60/40 portfolios since 2008, when the financial crisis dragged stocks down by nearly 40%.

Last year was also the sixth worst year ever for 60/40, according to Morningstar’s director of global ETF research Ben Johnson, who is sympathetic to investor angst.

“It’s been easy to forget that long-term investment returns are predicated on taking a degree of risk, and many investors might have been lulled into a false sense of security,” Johnson said. “Unique last year was the degree to which falling bond prices contributed to the negative performance of a 60/40 portfolio.”

While the 60% equity portion, as measured by SPDR S&P 500 ETF Trust (SPY), lost 18.2% last year, the fixed-income portion that's traditionally viewed as portfolio ballast was unable to hold its own in an environment that saw the Federal Reserve raise rates seven times to try and tamp down inflation, which still hovers around 8.5%.

Using the iShares Core US Aggregate Bond ETF (AGG) as a proxy, the 40% bond wedge lost just over 13% last year.

“All the research seems to generally assume that bonds go up and can’t have large losses,” said Paul Schatz, president of Heritage Capital.

“Bonds are a pillar of stability and income,” Schatz said. “But in real life last year, it was a complete and utter disaster for the bond market.” 

But that, as they say, is history.

Even though the start of any calendar year is little more than an arbitrary point in time in the grand scheme of the financial markets, the future in the form of 2023 looks quite bright for the 60/40 model.

“Very uncharacteristically for me, I am super positive on the 60/40 for 2023,” Schatz said. “My thesis is that both stocks and bonds this year are higher, and the 60/40 portfolio will do just fine to very well.”

Sam Stovall, chief investment strategist at CFRA, said investors and advisors have the momentum of history on their side.

“Over the last 50 years, whenever 60/40 has been down, it was up the following year 75% of the time, with an average gain of 13%,” he said.

While stock market declines are almost always the reason 60/40 models go down, Stovall said the uniqueness of 2022 contributes to putting some of the ballast back on the fixed-income side.

“Now that rates have risen as much as they have and the possibility of recession, I’d think bonds in 2023 would end up being the ballast they have traditionally been,” he said. “You have a rare situation where, only if you expect this bear market to be similar to 2000 and 2002 should you expect a repeat to downside.”

Todd Schlanger, senior investment strategist at The Vanguard Group, said the tumblers are in line and that “the outlook for a diversified portfolio is better than it’s been in a long time.”

After a decade of valuations creeping higher, Schlanger said the carnage of 2022 has given financial markets some room to run.

He explained that a year ago, U.S. equity valuations were in the 95^th percentile of historical valuations, suggesting a very rich market. That compares to U.S. equity valuations today in the 70^th percentile, which is still high but with more upside potential.

It’s a similar picture for bonds, which have valuations in the 44^th percentile, down from the 64^th percentile this time last year.

International equities have also become more attractive, with valuations in the 34^th percentile, down from the 57^th percentile a year ago.

“The bright news story is that now bonds are yielding more than double what they were last year,” Schlanger said. “For the long-term investor, the outlook is much brighter today than it was a year ago.”