ESGB - Is The 60/40 Balanced Portfolio Broken? Not Forever

2023-04-07 05:30:00 ET

Summary

• The promise of diversification failed in 2022 as both equities and fixed income declined.
• Some investors are questioning whether the traditional 60% equity/ 40% fixed income balanced portfolio remains a valid strategy.
• Over history, balanced portfolios have rebounded quickly from declines.

Everyone knows it by now: 2022 was not a kind year for investors, particularly balanced fund investors. There were no silver linings, no shelter from the storm; it seemed that no matter what levers you had in place to protect clients’ wealth, there was very little to cheer about on investor return statements.

Clients are probably asking themselves (and you): how did this happen? While we can point to a number of likely causes (stubbornly high inflation, central bank tightening, increasing recession risk), I think we can sum it up by admitting that in 2022, the promise of diversification… failed.

When I think of diversification, I think of the classic mix of 60% equities and 40% fixed income commonly known as 60/40 that we’ve all know and trusted for more than seven decades.

When Nobel Laureate Harry Markowitz introduced the 60/40 investment portfolio in his dissertation on Modern Portfolio Theory in 1952, it fundamentally altered the way that both individuals and institutions would invest. Markowitz demonstrated what many before him had not uncovered: that the performance of an individual security mattered less in an overall, well-diversified portfolio. It meant that investors could reduce their portfolio’s risk by investing in a mix of securities that differed in asset classes, capitalization, industries, geographies and return profiles. For years, his theory was proven right. A 60/40 portfolio generally provided a smoother ride for investors than pure equities.

Fixed income has historically been considered the ballast in a portfolio, offering stability and diversification against equity market fluctuations. Over the last 43 years, a balanced portfolio of 60% U.S. equities and 40% U.S. bonds would have returned 9.6% annualized with standard deviation of 11.3%. While a portfolio consisting solely of fixed income would have had lower return with lower risk, a portfolio consisting solely of equities would have had only slightly higher return but substantially higher risk.

Source: Morningstar Direct. U.S. equities=S&P 500 Index, U.S. bonds= Bloomberg U.S. Aggregate Bond Index. Balanced Portfolio=60% S&P 500 Index, 40% Bloomberg U.S. Aggregate Bond Index. Indexes are unmanaged and cannot be invested in directly. Past performance is not indicative of future results. Volatility is measured by standard deviation. Standard Deviation is a statistical measure of the degree to which an individual value in a probability distribution tends to vary from the mean of the distribution. The greater the degree of dispersion, the greater the risk.

2022 was a bit of an unusual year in that regard. Both stocks and bonds posted negative returns, which has only happened three times over the last five decades. Investors that would have once counted on the stability of fixed income to counter the volatility of equities, were left stranded. Can you blame them for questioning the validity of this asset mix going forward?

Source: Morningstar Direct. 60/40 Portfolio comprised of 40% S&P 500 Index, 20% MSCI EAFE Index, 40% Bloomberg Aggregate Bond Index. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly.

Where do we go from here? At Russell Investments, we believe the 60/40 strategy is poised to make a comeback in 2023.

Reasons for optimism about bonds

There are a lot of reasons to be optimistic about bonds this year, and not only because it seems that inflationary pressures are finally easing, or that central banks are nearing the end to their tightening cycle. Whether or not you consider it a fixed income renaissance , the fact is that bond yields are at multi-year highs. Higher yields mean that investors can be better protected against future rate increases and if there were to be a recessionary storm, this is a better position for investors to be in, potentially reasserting fixed income’s role as the risk offset to equity market volatility.

While we do see the potential for a mild recession in the next 12 months, one silver lining coming into this year is that investors have choice. One silver lining of the painful fixed income adjustment is that we are finally escaping the world of TINA—there is no alternative—where ultra-low interest rates forced investors into equities and a risky search for yield. Higher interest rates mean that TARA—there are reasonable alternatives—is now a better description of the investment opportunity set.

The return of TARA signals that the traditional balanced portfolio made up of 60% equities and 40% fixed income is poised to make a comeback after its worst year in living memory.

When you further diversify a portfolio by adding global equities, there is even greater potential for a smoother ride, The chart below shows that a 60/40 globally balanced portfolio has rebounded from past declines, with the strongest gains coming in the 12 months immediately after a bad stretch. As 2023 hits its stride, we can already see signs the 60/40 global portfolio is recovering from the rout it experienced in 2022.

Sources: 60/40 Portfolio comprised of 40% S&P 500 Index, 20% MSCI EAFE Index, 40% Bloomberg Aggregate Bond Index. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly.

The bottom line

Are we going to be okay? In our view - yes. As we all have heard quite regularly: Past performance is not an indicator of future returns. Last year was a challenging one, an anomaly, but as we’ve said before, there is tremendous value in reminding clients of the bigger picture and sticking to the investment plan. Asset allocation strategies may be bruised, but we do not believe they are broken.

Disclosures

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.

This material is not an offer, solicitation or recommendation to purchase any security.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment. The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual entity.

Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the "FTSE RUSSELL" brand.

The Russell logo is a trademark and service mark of Russell Investments.

This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an "as is" basis without warranty.

Russell Investments Financial Services, LLC, member FINRA , part of Russell Investments.

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.

This material is not an offer, solicitation or recommendation to purchase any security.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment. The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

Diversification and strategic asset allocation do not assure a profit or protect against loss in declining markets.

The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual entity.

The S&P 500® Index , or the Standard & Poor's 500, is a stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ.

MSCI EAFE (Europe, Australasia, Far East) Index: A free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada.

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