​The 60-40 Is Not Dead, It Just Needs CPR

As Green Day sings ever so eloquently in their song Good Riddance, “Time grabs you by the wrist and directs you where to go”. Whilst cliché, and also the only song I’ve ever learned how to play on the guitar, the message that time brings change in all aspects of life remains the same. Throughout the past ten years of financial markets, investors - both institutionally and individually - have been directed towards relatively risky portfolio allocations as they chase double-digit gains.  

It therefore bears the question: is the 60-40 still the optimal portfolio to maximize risk-adjusted returns, or as time changes, in the same light as Good Riddance, should portfolios change their direction as well?  

The 60-40 portfolio refers to a relatively balanced portfolio consisting of 60% equities and 40% fixed income instruments, which mainly includes but is not limited to bonds. While its initial origins are unclear, the investment strategy has been a common tactic implemented by retail and institutional investors alike. However, in the present state of capital markets, with everyone seemingly bragging about their massive returns from equities and alternative assets, many have started to question the validity of the 60-40’s thesis.  Moreover, returns that were unheard of in previous generations have acted as a catalyst towards investors’ risk appetites and subsequent portfolio allocations.  

An investor’s reasoning for implementing this specific investment strategy naturally varies. However, many believe that the 60% allocated to equities allows for adequate capital appreciation, and the 40% allocated towards bonds offers consistent income streams to stay agile and build capital, while also potentially mitigating a portfolio’s overall risk.  

The 60-40 portfolio was extremely successful in times of high bond yields relative to equity yields. A yield represents the return of an investment over a set period of time, expressed as a percentage. With higher yields came higher margins of safety regarding the initial capital an investor put into these fixed income investments. For instance, between 1980 and 2010, the Barclays Aggregate Bond Index had an average yield of 7.7%, far exceeding the S&P 500’s dividend yield. Additionally, during this period, there was negative correlation between bond yields and equity yields, meaning that the thesis held true that the 40% fixed income allocation hedged a portfolio’s overall risk to equity markets.  

Nonetheless, in the past twelve years, the success of the 60-40 portfolio has been underwhelming considering how strong equity performance has been. For context, the S&P 500, which represents 500 of the largest corporations traded on stock exchanges in the USA, has produced a return of over 300% since 2009. Further, with low interest rates came low bond yields, reducing investor’s returns in the 40% fixed income part of their portfolio. Additionally, with low interest rates came lower costs of debt for various public companies, allowing them to expand at a rate never seen before, naturally boasting higher than average returns on equities. The bull market in equity markets was only exacerbated by major technological advancements in various industries and the mass printing of money that allowed corporations to profit immensely.  

Moreover, underwhelming risk-adjusted returns in recent years brings the question to light: if the 60-40 is a strategy of the past, what is the strategy of the future? No answer is correct, as no one can predict what will happen tomorrow, let alone 5, 10, or 20 years down the line. There are many interesting strategies that investors new and old alike are implementing - with the highest returns likely coming from a mix between many of them. However, there is one aspect that will likely play a large factor- inflation.  

Inflation seems to be an issue that is always talked about as if its right around the corner, but is something that is hard to truly grasp its effects as it moves so subtly year over year. However, inflation is very real; just ask your parents how much a hamburger or t-shirt cost when they were kids.  

The COVID-19 pandemic brought unprecedented capital infusions from governments all over the world to stimulate the economy. Total COVID relief costs of $5.2 trillion dollars exceeds the $4.7 Billion spent on World War Two, adjusted for today’s dollars. Treasury Secretary of the USA Janet Yellen spoke to Bloomberg on June 19th, sharing that she expects the economy to slow and high inflation to remain rampant for at least the rest of the year. 

The repercussions on financial markets have a domino effect; as inflation rises and rises, central banks will raise interest rates. Further, the US Federal Reserve recently raised interest rates by 0.75 percentage points, which they have only done one other time in history. As interest rates rise, so does the cost of capital for companies, lowering their overall valuations as they now must spend more and more to operate at the same level as before, and their present value of future cash flows decrease.  

Moreover, the 60-40 is not dead, but it needs CPR to keep it alive against the imminent threat of inflation and rising interest rates.  

One common way that investors have been beating the market for years, and are poised to continue in some form, is alternative assets. The CFA institute classifies alternative assets as “supplemental strategies to traditional long-only positions in stocks, bonds, and cash”.  

Ultimately, investors should deviate a percentage of their equity allocations into hard, tangible, alternative assets such as real estate or gold. While gold is a true inflation-hedge - there is only a finite amount and demand does not significantly vary based on economic cycles - real estate also is an attractive investment in times of market turmoil. People always need places to live, work, and play. Not only that, but as interest rates go up, real estate investors may have to de-leverage their portfolios and sell off properties at relative discounts to peak valuations.  

Over 64% of homeowners’ properties are financed via mortgages or other types of loans. Thus, as interest rates go up, many people won’t be able to keep up with interest payments and be forced to sell. New home buyers won’t be able to borrow as much money, which will stop driving prices up. There will be chances to buy relatively cheap real estate as inflation continues to rise with interest rates, and investors should be actively pursuing possibilities in that regard.  

It has been without a doubt a special decade for equity performance. However, with inflation expecting to be and remain elevated for some time, and central banks determined to combat it by raising interest rates at paces almost ground-breaking, it is time to think about resuscitating one’s 60-40 portfolio to include alternative assets such as real estate.