These days, it’s fashionable to bury the conventional investment strategy of investing 60% of a portfolio’s assets in stocks and 40% in bonds. In September, CNBC ran an article by an investment professional claiming that the 60/40 portfolio had become obsolete. A month later, Barron’s wrote that the 60/40 approach “hasn’t worked,” before following up in November with an article titled “The 60/40 Portfolio Is Dead.” This January, the consumer money site Kiplinger’s agreed.
Ten years ago, similar claims abounded. In March 2009, an investment organization published “The Death of 60/40.” Shortly thereafter, the most famous fund manager of the time, Pimco’s Bill Gross, also ended the strategy. (The story has since been removed from The Wall Street Journal’s site, but this message board discusses its argument.) Several other money managers agreed.
It’s understandable why 2009 investors were wary of 60/40 portfolios. Although some US stocks had prospered, with energy stocks and real estate mutual funds posting annualized returns of 10% over the decade, the major stock indices had lost money. Thanks to his bonuses, most of the 60/40 portfolios had ended up in the black, but only slightly. The real money was made elsewhere.
The “elsewhere” consisted of alternatives: hedge funds, real estate, and private equity. Although all three investments fell along with the stock market during the 2008 global financial crisis, the first two had navigated smoothly during the 2000-2002 tech meltdown. As a result, funds that had diversified into alternatives had little trouble outperforming their more traditional competitors.
Yale vs Vanguard
I have compared the asset allocation used by the Yale endowment fund and 2) Vanguard Balanced Index (VBINX), over the 10-year period from July 1, 2001 to June 30, 2011. (The financial year of Yale runs through June, not December.) With two-thirds of its holdings in alternative securities, the Yale fund epitomized the modern investment approach, while the Vanguard Balanced Index followed the traditional path.
(To assess the allocation results, comparing the actual performance of the Yale fund to that of the Vanguard Balanced Index would be misleading, because Yale manager David Swensen selected stocks very shrewdly. I have therefore recalculated Yale’s performance showing how the fund would have done if it had used the same allocation, but instead of buying individual stocks, it owned indices).
Vanguard Balanced Index had not been bad, as it had outperformed inflation during those years. However, the fund suffered a lot of volatility along the way, including a 32.6% drop during the global financial crisis. That was a huge loss for a strategy that only generated a moderate reward. Surely investors could improve their prospects by adding alternatives, most of which had outperformed the Vanguard fund.
In addition, fixed income yields had shrunk, lowering the expected returns for bonds in a 60/40 portfolio. Fixed income securities would still serve as a drag, offering at least some protection against stock market swings, but their returns would be anemic. Stocks wouldn’t generate outsized returns, either. His assessments weren’t particularly convincing, especially as economists expected corporate earnings growth to be sluggish for the foreseeable future.
Or so it seemed to be the case in 2011. To everyone’s surprise, the 60/40 portfolio quickly blew away the competition. It didn’t outperform Yale for the next decade, thanks to David Swensen’s continued (and unmatched) ability to identify the best investment managers in advance, but this time the 60/40 strategy outperformed Yale. It’s an impressive achievement, given that Yale invested heavily in venture capital and leveraged buyout funds.
The 60/40 portfolio also comfortably led so-called “risk parity” strategies, another form of alternative investment that had become popular in the wake of 2008. To summarize, risk parity funds downplay stocks in favor of other investment assets. The few risk parity funds that existed during the 2000s outperformed 60/40 portfolios. However, as evidenced by the returns of the S&P Risk Parity Index: 10% Target Volatility, the 60/40 portfolios matched the score.
To give contemporary 60/40 skeptics their due, they have broken with investment tradition by disparaging a recently successful strategy. That’s a refreshing break from the norm. That said, the underlying logic of the 60/40 skeptics hasn’t changed much in the past decade. Once again, they are wary of 60/40 portfolios because bond yields have become too low and stock price/earnings too high.
Perhaps so, but as the last decade has shown, it is certainly possible for bond yields to decline further and for stock valuations to continue to rise. Besides, who’s to say that substitutes for a 60/40 portfolio will be an improvement? After all, alternative investments consist of stocks in a different wrapper (such as private equity funds, venture capital funds, or leveraged buyout funds) or real assets, many of which are also aggressively priced. For example, the price of gold bullion has risen 50% in the last three years, and despite vacancies caused by the coronavirus pandemic, the price of commercial real estate in the US has skyrocketed.
In Barron’s second article, five investment advisers were asked how they would modify the 60/40 formula, given current conditions. Each recommended selling bonds. Two would replace those bonds with publicly traded stocks, while the other three would do so with a mix of alternative stocks and real estate. In other words, the five would make the 60/40 portfolio riskier to compensate for the fact that the bonds can no longer be expected to offer an adequate return.
play with bonuses
My own advice (if I offered such a thing) would take the opposite course. Avoid the temptation to become more aggressive when investment opportunities seem slim. Instead, maintain the same 60% equity position, but consider reducing the portfolio’s bond market risk by trading for shorter notes or even raising cash. If long-term Treasury yields continue to rise, as they have since the summer of 2020, that money can gradually be reinvested in longer-dated securities.
But that’s just a soft and temporary suggestion. More generally, I don’t question the wisdom of the 60/40 portfolio. Ten years from now, I’ll probably write a follow-up column demonstrating how the strategy is still valid.