A playbook for COVID uncertainty – the 60/40 portfolio
The 60/40 portfolio, also known as the balanced portfolio, is a staple for long-term strategic investors. Composed of 60% U.S. equities and 40% investment-grade bonds, this allocation has historically offered resilience during periods of volatility and achieved decent gains during bull markets, helping investors achieve their goals.
The key idea here is balance. The equity allocation allowed the portfolio to grow – outpacing inflation –while the investments in fixed income provided a diversification hedge. Since 1989, the combined portfolio has delivered more than 80% of the of the return of the stock market (S&P 500 index) with only slightly more than half the risk.1 The portfolio has also experienced lower historical drawdowns (peak to trough declines) than the equity market.
The 60/40 portfolio showed its strength in 1Q20 despite declining -10.5%, its second worst quarter of performance going back to 1988. That sounds dire, but the S&P 500 was down more than 20% from its January highs over that same period. By comparison, the period provides a solid example of the portfolio’s ability to weather a tumultuous quarter.
Still, the balanced 60/40 portfolio has come under increased scrutiny as the diversification benefit – particularly notable during periods of stress – has waned since 2015. For the last five years, investors have pointed to a decline in the diversiﬁcation benefit from pairing stocks with bonds.
Part of this change is due to a structural change in the broader economy. Policy interest rates are low – close to zero. “Low for long” interest rates and a global search for yield have also brought investment-grade bond yields to all-time lows. Low bond yields mean high prices, leaving less space for bonds to appreciate and buffer equity drawdowns.
Looking ahead, the traditional asset mix may get less help from bonds when times get tough. From that vantage point, it’s easy to speculate that the balance typically enjoyed by 60/40 investors is no longer effective, but we doubt the approach is ‘doomed’.
Correlation shifts over time
Sources: Multi-Asset Solutions team, Bloomberg, 4/16/20. Correlation is a statistic that measures the degree to which two securities move in relation to each other. In this case we are measuring the correlation between stocks (S&P 500 Index2) and Bonds (Bloomberg U.S. Aggregate Bond Index3).
In fact, we see two key reasons why these fears may be misplaced:
1. Diversification works better over longer time periods. The correlation (the measure of price change in two assets) has been less negative. So, when stocks go down, bonds don’t always go up – which means less balance. The 60/40 portfolio ‘hedge’ appears less powerful in short time periods.
However, over longer time periods (i.e. a quarter, year, or decade), the correlation and the hedging power of bonds hold – particularly during the most recent equity market setback.
Sources: Multi-Asset Solutions team, Bloomberg, 4/16/20. Correlation is a statistic that measures the degree to which two securities move in relation to each other. In this case we are measuring the correlation between stocks (S&P 500 index) and Bonds (Bloomberg U.S. aggregate bond index). We average 1-month rolling daily correlations to approximate a longer-term average correlation.
2. Returns (and inflation) are likely to be lower overall. Bond yields are low, but equity price multiples are also high. That means future returns may be lower in both asset classes. However, yields are presumably low for a reason – inflation expectations are low. Investors may not need as much “juice” from equities to outpace inflation, and bonds may still support equities on the downside.
With the right approach, now, may be the best time to take a balanced approach to investing.
A captain at the helm
Amid strong economic and market uncertainty, it is helpful for investors to stick to a road map: a set of rules or a playbook to navigate rough seas. The 60/40 has long been considered a reasonable strategic allocation for many investors. And we believe it still is. With information about the future being highly imperfect, investors may benefit from adhering to this balance, especially when big price swings make errors more costly.
That said, small changes to the traditional 60/40 portfolio may improve outcomes:
- Rebalancing: With valuations higher, and expected returns lower, a portfolio needs all the help it can get. That means keeping your weights in balance – Particularly after a big swing in prices. For example, a portfolio allocated to 60% stocks and 40% bonds at the start of 2020 would have shifted to about 53% stocks and 47% bonds by the end of the first quarter. As equity markets recovered, over a 16-day period, a rebalanced portfolio would have outperformed the drifted portfolio by almost 2%.
- Diversified sources of return: For some investors, it may be appropriate to lean into diversified sources of return potential. From 1980 – 2020 adding non-traditional fixed-income asset classes – sourced via equities –generated additional return with the same level of risk. Allocations to high-yield bonds, convertible bonds, short duration high-yield bonds, and some alternative strategies may be useful for investors with the appropriate risk tolerance.
- Tactical allocations: When the fog of uncertainty clears and the virus-related issues abate, taking additional tactical risk in a portfolio may be appropriate for some investors.
- Security Selection: During times of crisis, we firmly believe investors should favor security selection rather than buying “everything and anything.” We like quality companies that are at a discount with: good management teams with proven business models.
- Based on a hypothetical portfolio of 60% S&P500 Index and 40% U.S. investment grade bonds (Bloomberg Barclays U.S. Aggregate bond index. The hypothetical portfolio was rebalanced daily. Performance was measured using average annualized returns. Risk was measured using average annualized standard deviation.
- The S&P 500 Index measures the stock performance of 500 large companies listed on stock exchanges in the United States.
- Bloomberg Barclays U.S. Aggregate Bond Index is a broad base, market capitalization-weighted bond market index representing intermediate-term investment-grade bonds traded in the United States.
This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.
The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.
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