How Inflation and Rising Interest Rates Affect the 60/40 Portfolio Strategy

How a 60/40 Portfolio Strategy Works

The strategy allocates 60% to stocks and 40% to bonds — a traditional portfolio that carries a moderate level of risk.

More generally, “60/40” is shorthand for the larger theme of investment diversification. The thinking is this: when equities (the growth engine of a portfolio) are performing poorly, bonds serve as ballast because they often don’t move in tandem.

The classic 60/40 combination encompasses U.S. stocks and higher-quality bonds (like U.S. Treasuries and high-quality corporate debt), said Amy Arnott, portfolio strategist for Morningstar.

Market conditions accentuated the 60/40 mix

Until recently, the combination was hard to beat. According to recent analysis by Arnott, investors with a basic 60/40 combination achieved higher returns over each three-year period, from mid-2009 to December 2021, compared to those with more complex strategies. .

Low interest rates and below-average inflation supported stocks and bonds. But market conditions have fundamentally changed: interest rates are rising and inflation is at its highest level in 40 years.

US stocks responded by plunging into a bear market, while bonds also fell to a degree not seen in many years.

As a result, the 60/40 portfolio is in trouble: it was down 17.6% this year through June 22, according to Arnott.

If sustained, this performance would rank only behind two Depression-era downturns, in 1931 and 1937, which saw losses exceeding 20%, according to an analysis of historic 60/40 annual returns by Ben Carlson. , Director of Institutional Asset Management at Ritholtz Wealth Management.

“There is still no better alternative”

Of course, the year is not over yet; and it’s impossible to predict if (and how) things will get better or worse from here.

And the list of other good options is slim, at a time when most asset classes are hammered, according to financial advisers.

If you have money right now, you are losing 8.5% per year.

Jeffrey Levin

planning director at Buckingham Wealth Partners

“Well, then you think the 60/40 portfolio is dead,” said Jeffrey Levine, CFP and chief planning officer at Buckingham Wealth Partners. “If you’re a long-term investor, what else are you going to do with your money?

“If you’re in cash right now, you’re losing 8.5% a year,” he added.

“There’s still no better alternative,” said Levine, who is based in St. Louis. “When faced with a list of inconvenient options, you choose the least inconvenient.”

Investors may need to recalibrate their approach

While the 60/40 portfolio may not be obsolete, investors may need to recalibrate their approach, experts say.

“It’s not just the 60/40, but what’s in the 60/40” that’s also important, Levine said.

But first, investors need to review their overall asset allocation. Maybe 60/40 – an intermediate strategy, not too conservative or aggressive – just isn’t for you.

Determining the right one depends on many factors that oscillate between the emotional and the mathematical, such as your financial goals, when you plan to retire, life expectancy, your comfort with volatility, the amount you want to spend in retirement and your willingness to pull back on those expenses when the market goes haywire, Levine said.

Rebalancing for the second half

While bonds have moved in line with stocks this year, it would be unwise for investors to abandon them, Arnott told Morningstar. Bonds “still have significant benefits for risk reduction,” she said.

The correlation of bonds to equities has risen to around 0.6% over the past year, which is still relatively low compared to other equity asset classes, Arnott said. (A correlation of 1 means the assets track each other, while zero implies no relationship, and a negative correlation means they move across from each other.)

Their average correlation has been largely negative since 2000, according to Vanguard research.

The S&P 500 Index is down 21% in 2022 and the Bloomberg US Aggregate Bond Index is down 11%.

“It will probably work in the long run,” Roth said of the benefits of bond diversification. “High-quality bonds are much less volatile than stocks.”

Diversification “is like an insurance policy”

The current market has also demonstrated the value of greater investment diversification within the stock-bond mix, Arnott said.

For example, adding diversification within equity and bond classes on a 60/40 strategy resulted in an overall loss of around 13.9% this year through June 22, an improvement over the 17.6% loss of the classic version incorporating US stocks and investment-grade bonds, according to Arnot.

(Arnott’s more diversified test portfolio allocated 20% each to US large-cap stocks and investment-grade bonds; 10% each to developed and emerging market stocks, global bonds and high-yield bonds; and 5% each to small cap stocks, commodities, gold and real estate investment trusts.)

“We haven’t seen these [diversification] for years,” she said. Diversification “is like an insurance policy, in that it has a cost and it doesn’t always pay off.

“But when it does, you’re probably glad you have it,” Arnott added.

Investors looking for a hands-off approach can use a target date fund, Arnott said. Fund managers maintain diversified portfolios that automatically rebalance and reduce risk over time. Investors should hold them in tax-advantaged retirement accounts instead of taxable brokerage accounts, Arnott said.

A balanced fund would also work well, but asset allocations remain static over time.

Do-it-yourselfers should ensure they have geographic stock diversification (beyond the US), according to financial advisers. They may also want to favor “value” stocks over “growth” stocks, because company fundamentals are important during tough cycles.

Relative to bonds, investors should favor short to mid-term bonds over longer-term bonds to reduce the risk associated with rising interest rates. They should probably avoid so-called junk bonds, which tend to behave more like stocks, Roth said. I bonds provide a safe hedge against inflation, although investors can generally only buy up to $10,000 per year. Treasury inflation-protected securities also provide a hedge against inflation.

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Don F. Davis