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The 60/40 is alive and thriving! After repeated calls for its ultimate demise, the past 20 months have been nothing short of spectacular. As a reminder, the 60/40 portfolio comprises 60% stocks and 40% bonds. This composition helps diversify and reduce a portfolio’s risk, given the rarity of stocks and bonds declining in the same year. While the 60/40 is used as a proxy for diversification, most investors hold a different ratio of stocks depending on various personal factors.
Many investors have a hard time accepting that a portfolio of stocks and bonds can consistently lead to positive annual returns. Their premise is that investing has evolved over time and that a portfolio of only stocks and bonds no longer cuts it. They believe additional asset classes, such as alternatives and private equity, need to be incorporated into the portfolio. While these asset classes can perform well, they generally bring more unpredictability, lower liquidity, and a shorter track record.
So why am I bringing this up now? It’s simple: follow-through. Making bold predictions is easy; seeing them through is another.
The year 2022 was difficult, as consumers felt the pain of surging inflation in nearly every aspect of their daily lives. This surge led the Federal Reserve to raise the fed funds rate from .25% to 4.5%. Raising interest rates in this magnitude is pretty much unheard of and a large reason why both stocks and bonds experienced sharp declines.
This simultaneous decline brought the pundits out of the woodwork yet again, calling for the demise of the 60/40. Truthfully, this time did feel somewhat different. Not only were the calls louder, but the bond market had just finished its worst annual decline in history. The assumption was that elevated inflation was here to stay!
As of this writing, the 60/40 has returned ~30% since the start of 2023. Even with no additional gains, this will go down as one of the best two-year stretches in the past 20 years! The cherry on top is that both stocks and bonds have rallied significantly.
Much of this change can be attributed to the decline in inflation coupled with the Fed’s indication of interest rate cuts in September. This sparked a significant rally as cheaper borrowing costs can help spur additional economic growth while avoiding a recession, and lower interest rates make bonds more attractive on a relative basis.
This type of rally seemed impossible at the start of 2023, when the outlook was bleak, especially for bonds. Now, Q1 of 2023 delivered much of the same, and negative sentiment continued to mount.
As I like to point out, markets tend to rally when negative sentiment is at its highest. It’s hard to block out the noise—it truly is—but the fact is that stocks and bonds have been around for 90-plus years, and there is just about nothing they haven’t seen before. And guess what? They have bounced back each and every time. Will there eventually be a prolonged period where markets underperform or take longer to rebound? Of course, but those are the exceptions, not the rule.
While U.S. economic growth is clearly cooling, I am actually encouraged by the 60/40 portfolio moving forward. Why? Quite simply, bonds are “back.” This means they should act as a normal diversifier moving forward. The year 2022 and the first half of 2023 were outliers, and barring an unexpected prolonged spike in inflation, interest rates have peaked.
With the U.S. economy cooling, the Fed is more likely to cut rates. This means bonds will not only provide a solid yield but should rally during stock market declines. Case in point, as seen on the chart below, the S&P 500 just recently declined -8.4%, while the U.S. Aggregate Bond Index rallied +2.1%. This is what normally happens in the face of volatility: Bonds rally.
It should be noted that the S&P rallied significantly and recouped nearly all the losses in a mere two weeks! Why? Additional data showed that the U.S. economy isn’t slowing as much as feared.
Look, investing based on market headlines is a fool’s errand, so your best bet is to ignore them. While there are no guarantees, the 60/40 appears to be on solid footing. This is something that needs to be appreciated as market volatility isn’t going to disappear, but with bonds acting normal again, there is reason to be cautiously optimistic.
Discuss your situation with a fee-only financial advisor.