It’s settled: The 60/40 balanced portfolio is alive and well.
It’s surprising how long this debate has been going on in the industry. The fear and trauma caused by market losses in 2022 can understandably lead investors to operate with recency bias — the behavioral tendency to extrapolate the most recent experience into longer-horizon views and decision-making. But some who profess the death of the 60% stock/40% bond portfolio have gone further, saying that inflation and positive stock-bond correlations are here to stay.
Let’s do a reality check and take a look back and forward.
Even with its nearly 16% loss in 2022, the 60/40 portfolio has managed to deliver normal returns on average over longer time periods. The 10-year annualized return as of the end of 2022 was a bit more than 6%. The annualized return for the four years through 2022 — which includes the Covid years as well as last year’s market rout — is again close to 6%. (The –16% return in 2022 was preceded by an impressive 51% cumulative return from 2019 to 2021).
Moreover, Vanguard projects the 60/40 to continue performing well over the long run. According to the Vanguard Capital Market Model, the median expected annualized return is in the 5% to 6% range over the next 10 years. The stability of the average annual performance, both historical and projected is striking. The 60/40 is doing its job as intended.
Our conviction about the resilience of the 60/40 portfolio is based on our view that the inflation shocks of 2021 to 2022 and the reset in interest rates from historically lows levels are unlikely to repeat in the years ahead. The dual shock of steep inflation and steep rate hikes were part of one-time adjustment to the global dislocations of Covid and the extreme policy stimulus used to restart the global economy.
A repeat of simultaneous, correlated losses in stocks and bonds would necessitate the continued movement upward of inflation and interest rates. That would be a full-blown 1970s-style stagflation scenario — something that in our view is unlikely. Central banks have already acted decisively, even at the risk of a global recession, and as a result, inflation is already moving gradually downwards. Year-to-date performance of the 60/40 is already back in line with long-term normal average of 6%!
Years of underperformance preceded by years of outperformance is the essence of long-term investing. The 60/40 continues to be a sound long-term strategy. It embodies universal principles of successful investing: diversification, disciplined exposure to risk premiums and cost efficiency.
This isn't to say that the 60/40 is the right portfolio mix for everyone in all situations at all times. The formula can and should be calibrated to unique investor needs. The headwinds to 60/40 aren't from inflation or market volatility. Instead, three structural trends are increasingly challenging the one-size-fits-all 60/40 recipe:
• Additional sources of portfolio value beyond broad stock and bond indices.
• Evolving understanding of the fundamental drivers of asset risk premiums.
• Modern technology enabling personalization of portfolios at scale.
First, the key engine of growth in the 60/40 is the disciplined long-term exposure to equity and bond returns, along with the imperfect correlation between them. This idea of harvesting long-term risk premiums can be extended to a wider set of low-cost, well-diversified investments beyond broad stock and bond exposures — among them certain factor strategies, emerging market bonds, high-yield bonds, inflation-linked bonds, commodities futures, liquid alternatives and private assets. Just like stocks and bonds, each of those asset classes can provide enduring sources of return above cash. A modern balanced portfolio should follow the same principles as the 60/40 but it may feature exposure to a broader variety of compensated risk factors.
Second, since the 1990s academics and industry thought leaders have gained a clearer understanding of the systematic (albeit imperfect) drivers of equity and bond risk premiums and how they change across different market conditions. For instance, when stocks are cheap, subsequent equity returns are typically higher, and vice versa after periods when stocks were expensive. Similarly, bond yields are a fairly good proxy for the return to be expected on a bond fund over the long term.
Modern balanced portfolios may adjust allocations based on relative valuations in the current market environment. Balanced investing doesn’t necessarily mean static investing.
Third, the cost efficiency of the 60/40 stems from the scale achieved via a one-size-fits-all approach. However, cost efficiency can also be achieved with digital technologies. This is critical given the increasing need for portfolio customization in personal financial advice, which goes against economies of scale.
One-size-fits-all at scale is giving way to digital technology and hyper-personalization. Modern balanced portfolios are being optimized with algorithms. This allows for customization along various dimensions — the investor’s unique attitude toward risk, different portfolio goals, and preferences or beliefs. Goal-oriented portfolios can range from generic wealth growth to specific goals such as income targets, tax efficiency or inflation-risk hedging. Preference or beliefs can include ESG objectives, conviction in a specific active manager, or ad hoc constraints to specific assets.
Addressing the three structural trends involves building upon the foundation of the 60/40 portfolio, not dismissing it. Embodying the principles of sound investing, the 60/40 is still the bedrock on which modern portfolios are based on. Any death knells for it are not only premature, but erroneous altogether. End of debate.
Roger Aliaga-Díaz is global head of portfolio construction and chief economist for the Americas at Vanguard.
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