Why the 60/40 “Balanced” Portfolio is Dead & What You Can Do About It
To support this rather audacious claim, I would organize the arguments into two different groups. The first being challenges in the current market environment related to expected return and risk. The second group has to do with advances in investment management since the creation of the theory underlying the 60/40 portfolio 70 years ago.
#1) Let’s start by dealing with the first category. With equity markets still priced at very high valuations (the S&P 500’s trailing P/E ratio is still “consistent with levels seen in mid-2009, early-2000s, late-1990s, and early-1990s” courtesy of Schwab’s Liz Ann Sonders-see graphic below) even after this recent pullback, bond yields that have begun to rise, and with the Federal Reserve embarking on an interest rate hiking cycle, JP Morgan now estimates that over the next decade, the 60/40 stock/bond portfolio will only return 4.2% per year and that is a nominal return. After adjusting for inflation, it is only slightly positive.
Because of the high stock valuations, it will take time for the economy to grow into these valuations to justify them, which will subdue equity returns over the next decade. The 60/40 portfolio (or something close to it) it what the finance industry is referring to when you hear financial professionals talk about the “balanced portfolio.” The 60/40 “balanced portfolio” is based on a theory (Modern Portfolio Theory) developed by Harry Markowitz in the 1950s. The theory assumes the bond side of the portfolio offsets losses in the equity side when the equity side incurs losses and it also assumes the bond side of the portfolio is safe (not always a true assumption). The problem is the bond side of the portfolio doesn't always move inversely to the equity side, meaning it doesn't always offset losses in the equity side of the portfolio. The second problem is that the bond side of the portfolio can lose. As of the date of my writing this (3/23/22), the 20 year Treasury bond has returned negative 12% YTD (at the same time equity markets are themselves are in correction territory). Often in finance textbooks, Treasuries are assumed to be risk free. The truth is they are only risk free from the perspective of default risk. They can and will lose when interest rates rise (bonds and yields on bonds move inversely), and bonds are more susceptible to losses when bond yield are low, as they are now.
#2) The second argument suggesting the 60/40 portfolio is dead is based on the fact that there have been advances in portfolio theory since the creation of Modern Portfolio Theory 70 years ago. These advances do not replace and negate the importance of the key tenets of MPT, but it does supplement them in a meaningful way. Modern Portfolio Theory only speaks about diversifying by traditional asset classes. And much of the way advisory firms implement Modern Portfolio Theory excludes alternative asset classes, which is not MPT’s fault, but an important observation. But MPT does always exclude alternative investment strategies which are part of a bucket of known as Daily Liquid Alternatives (which everyone can get exposure to), which again MPT does not include. The traditional assets classes encompassed by MPT includes US stocks, foreign stocks, emerging markets, bonds, real estate, gold, commodities, and cash. A more modern approach to portfolio theory says that portfolios should, among other things, also diversify by investing strategies, methodologies, time frames, and managers.
In traditional portfolio design (i.e. MPT), relying upon traditional asset classes, there can be real diversification benefits achieved. The only problem the diversification benefits are very limited. While they may not be perfectly correlated (i.e. have correlations less than 1.0) on most trading days when the markets are behaving normally, there are often strong correlations between these traditional asset classes when that diversification is needed the most. During the most severe market crises and crashes, there is a tendency for these traditional asset classes to have correlations that move towards one (which means they all, or many of them anyway, move south together).
One of the solutions that the capital markets bank Goldman Sachs recommends is to include an allocation to Daily Liquid Alternatives. In fact, in one of their base models, they suggest including an 18.7% allocation to DLAs (see graphic). These Daily Liquid Alternatives can include tactical trading strategies, equity long/short strategies, and hedged equity among others (see graphic). We won't get into exactly what these strategies entail, but there are ways for investors to get exposure to these alternative asset classes and strategies, that provide a more comprehensive and effective way of getting diversification benefits and employing risk management strategies in order to increase the robustness of portfolios when they need it and to better navigate the current market environment actually improving the (Sharpe) risk to return ratio.
Joshua Henry is the founder and Managing Principal of Meridian Financial Advisory, an independent, fee-based wealth management company located in South Carolina, serving people locally and across the country. Meridian focuses on providing wealth management solutions to affluent individuals over age 50 and their families. Joshua is passionate about helping people have a better life by designing and implementing customized financial plans that bring clarity and confidence. Joshua is a CERTIFIED FINANCIAL PLANNER™(CFP®) and earned a Bachelor of Arts degree in Political Science from Cedarville University and a Master of Business Administration degree with a concentration in Corporate Finance from Salve Regina University. The courses for the Corporate Finance concentration were taken from the Kelley School of Business at Indiana University. He has held workshops on Social Security Claiming Strategies, IRA Planning, and Career Coaching for Executives in between jobs. Josh has also taught finance at the university level. When he’s not working, Josh teaches adult Sunday School at his church in Pawley Island, SC. He enjoys traveling, reading, and time with his family. To learn more about Josh, connect with him on LinkedIn.