Diversification has not worked well thus far in 2022.
While the S&P 500 is down more than 12% this year, the bond market, which normally softens the blow when stocks drop, is off more than 9%. This performance has added fuel to the debate about whether a balanced portfolio, made up of stocks and bonds, is really a reliable investment strategy for individuals. The 60/40 portfolio, one comprised of 60% stocks and 40% bonds, has been proclaimed dead many times over its history. These days, the naysayer’s voices are growing louder.
Is it time to rethink asset allocation?
The balanced portfolio
The 60/40 strategy was an incredible tool for a long time. Consider that when rebalanced each year, the portfolio returned more than 9% annually from 1987 through 2021, according to data from portfoliovisualizer.com. This portfolio limits volatility by investing in asset classes that have historically moved in opposite directions (or are negatively correlated), thereby creating a level of stability that many investors have found comforting. That said, there were a handful of years when the return on this portfolio declined. Risk is inherent in any investing strategy, but for the most part, this portfolio has done a good job at mitigating that risk over time.
2022 – A sign of more pain to come?
This year that same portfolio is down more than 12% through May. It’s the worst drop since the 2008 Great Recession. While stocks have fallen sharply in response to concerns of a slowdown in growth, margin pressures, geopolitical events, and monetary policy changes by the Fed, bonds haven’t acted as the buffer they typically do.
Inflation has been the biggest driver of the weak bond performance. With inflation surging over the last year, interest rates started rising last December in a dramatic fashion. Keep in mind that bond prices fall when rates rise. Further pressuring bond values has been the signaling of, and now action, by the Federal Reserve. The Fed began lifting its target interest rate earlier this year and started offloading part of its massive balance sheet just this month in an effort to combat the highest inflation in 40 years. Combined, these forces have led to a swift move higher in yields, which is a tough environment to invest in bonds. These are key macro themes are significantly impacting the “40” part of the 60/40 portfolio.
A look back in time
Bonds usually zig when stocks zag, at least since the early 2000s. It was only for brief moments, such as around the 2008 drop and during the late-2018 bond market selloff when the two moved together. The negative stock/bond correlation since 2000 hasn’t always been the case, though. AQR, an asset management firm, found that the two asset classes moved together from the late 1960s through the late ‘90s – when rates rose, stocks sometimes dropped. That was no more evident than during the inflationary spiral of the 1970s and early ‘80s. Inflation often gets investors wondering about what else to own besides stocks and traditional fixed income.
Portfolio adjustments – other sources of yield
Real estate and gold are usually the go to investments when looking for inflation hedges. They have a history of performing well in periods of hot inflation. Infrastructure also performs well during inflationary times, and like real estate can offer attractive yields. These asset classes can be considered as ways to enhance the 60% equity portion of the traditional balanced portfolio, though shouldn’t be considered a replacement for fixed income. Take caution as fees can run higher in some of these alternative investments.
To enhance the fixed income portion of the portfolio, floating rate bonds or TIPS (Treasury inflation protection securities) could be considered given how quickly rates are moving. Remember though, this portion of the portfolio is not expected to drive big profits. Instead, it is used to simply preserve capital and generate steady income.
Any changes to your portfolio should be made with your goals and investment time horizon in mind.
The bottom line
This may not be the time to abandon the 60/40 portfolio. Some tweaks may be needed, but before making any changes evaluate if you believe inflationary and interest rate changes are structural and here to stay for an elongated period.
We’re going through an unusually painful period for investors, but we’ve been here before. While the 60/40 portfolio isn’t immune to the current environment, there remains hope that this tried-and-true guidepost for investing can return to its stable, reliable way. Ultimately, the path of inflation and interest rates hold the key to the future performance of the 60/40 portfolio.
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Lindsey Bell, Ally’s chief markets & money strategist, is an award-winning investment professional with a passion for personal finance and more than 17 years of Wall Street experience. Bell’s unique ability to connect the dots between data and real life and craft bite-sized money ideas that people can use and apply stems from her deep background as an analyst, researcher and portfolio manager at organizations including J.P. Morgan and Deutsche Bank. She is known for demonstrating why and how an understanding of all things money improves a person’s finances and overall well-being. An ongoing CNBC contributor, Bell empowers consumers and investors across all walks of life and frequently shares her insights with the Wall Street Journal, Barron’s, Kiplinger’s, Forbes and Business Insider. She also serves on the board of Better Investing, a non-profit focused on investment education.