Does the 60/40 portfolio still make sense?
Bonds can still provide portfolio benefits even if equity-bond correlations remain positive.
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The 60/40 approach to portfolio construction has long been a mainstay of investing – allocate 60% to equities for capital appreciation and 40% to bonds for income and potential risk mitigation.
It’s a simple investment strategy that has performed extremely well over the past two decades, as stock prices have risen in a near-straight line and interest rates have fallen to record lows, pushing up bond prices.
But some investors are now losing faith in this model amid the challenging macroeconomic environment.
For example, the S&P 500 Index fell 4.6% in the first quarter of 2022, as bond yields spiked and war broke out in Ukraine.
At the same time, soaring inflation and tighter monetary policy knocked the ICE BofA US Treasury Index down by 5.6%, robbing investors of their go-to shelter to cushion market losses.
Although equity and bond returns are seldom positively correlated, some fear that this trend could continue. However, this does not mean investors should completely shun bonds from their strategic asset allocation.
Bonds can still provide valuable portfolio risk reduction and diversification, even if equity-bond correlations remain positive.
Volatility matters more for risk reduction
There are two ways in which an asset can reduce portfolio volatility:
1) volatility effect: the effect of adding an asset with lower volatility than equities, even if this asset is perfectly correlated to equities.
2) correlation effect: the effect of adding an asset that has a low or negative correlation to equities.
Historically, a portfolio of bonds has been roughly half as volatile as stocks. Given this sizable difference, most of the risk reduction in a 60/40 has come from the lower volatility of bonds rather than their negative correlation with equities.
For example, since the year 2000, a 60/40 split has lowered portfolio volatility (versus holding equities only) from 15% to 8.6%. But just over a tenth of that reduction came from the negative correlation between equities and bonds while the rest was attributable to lower asset volatility.
So as long as bonds remain less volatile than equities going forward, a 60/40 portfolio can still look attractive from a risk perspective.
Risk/reward can still be attractive even if correlations spike
If all an investor cared about was reducing their portfolio volatility, one could argue that they should simply increase their allocation to cash.
But naturally there’s more to efficient portfolio construction than minimising risk. Investors also care about returns and whether they are being appropriately compensated for taking risk.
So how much do correlations and/or volatility need to increase to make you indifferent between a 60/40 versus just owning equities? The answer is a lot.
The table below shows what the expected return/volatility ratio might be for a 60/40 portfolio over a 10-year horizon using different correlation and volatility assumptions.
Based on our economics team’s return forecasts (4.1% p.a. for US equities and 2.9% p.a. for US bonds) and assuming the last 20 years of volatility persists, we find that equities offer an expected return/volatility ratio of 0.27 compared to 0.38 for bonds.
However, the risk-reward for the 60/40 still beats equities under nearly all assumptions about correlations and bond volatility. This means correlations and/or volatility would need to rise materially in order to blunt the appeal of the 60/40.
For example, let’s assume that equity-bond correlations increase to +0.6 – a level that was only briefly seen in the 1990s.
In this scenario, bond volatility would need to increase 2.8x from 5.4% today to 14.5% to make investors indifferent in terms of risk-reward between a 60/40 versus an equity-only portfolio.
The 60/40 portfolio is probably here to stay
The simultaneous sell-off in equities and bonds this year has alarmed investors. But when it comes to constructing an efficient portfolio, our analysis finds that correlations matter less you might think.
This is because most of the risk reduction in a 60/40 equity-bond portfolio comes from the lower volatility of bonds rather than their negative correlation with equities.
Looking ahead, bond volatility and/or correlations would need to rise materially in order to erode the risk-reward ratio of the 60/40 compared to holding equities only.
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