On the Life and Death of the 60/40 Portfolio

For decades, the 60/40 portfolio (a mix of 60% stocks and 40% bonds) was the standard for prudent diversification: an all-weather allocation that rested on the simple, but Nobel-winning, idea that spreading out risk exposure resulted in better risk-adjusted performance. But then came the dual bear market of 2022, in which stocks and bonds plummeted simultaneously to deliver the worst performance for the 60/40 allocation since the Great Financial Crisis of 2008-2009.  This led pundits across the industry to proclaim that the golden age of asset allocation was over, and that the underlying assumptions of asset class diversification were no longer valid. The 60/40 portfolio was dead.  

However, these claims fall short in their assessment of what the 60/40 portfolio truly represents, and perhaps more importantly, what it does not. As we will attempt to demonstrate, claiming that we have somehow moved beyond such an investment staple is simply to grossly misunderstand the fundamental principles that made it so popular in the first place.

The Basics: Markowitz’s Math

“It is the part of a wise man to keep himself today for tomorrow, and not venture all his eggs in one basket.” - Miguel de Cervantes, Don Quixote

The idea that risk and return are intrinsically linked was not a novel idea when Harry Markowitz published his seminal 1952 essay “Portfolio Selection,” nor was the concept of hedging your bets. But famous idioms aside, what Markowitz did, and what eventually earned him a Nobel prize (or, more precisely, a Sveriges Riksbank Prize in Economics Sciences) was to bring mathematical rigor to bear on the question of optimal asset allocation in the face of uncertainty.  The core premise of his work was simple: a good portfolio is more than just a collection of stocks and bonds – it is “a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingences.”ⁱ Markowitz observed that while each component of a portfolio (a stock, bond, or entire asset class) has a certain level of risk, if the components are not perfectly correlated – meaning simply that their prices do not move in lockstep with each other – you gain a diversification benefit by combining them. More formally, the overall risk of such a mixed portfolio would be lower than the weighted sum of each individual asset’s risk, meaning simply that by selecting such imperfectly correlated assets, investors could potentially achieve higher returns for each unit of risk they are taking on.  

When you take a step back, this observation is fairly intuitive. Beyond just splitting stocks and bonds, we categorize asset classes based on a number of shared characteristics, such as country of domicile (U.S. versus International) or size (large-caps versus small-caps). And based on these shared characteristics, each asset class is likely exposed to entirely different risk factors (economics, politics, geopolitics, natural disasters, etc.), or where they share risk exposure, to different degrees (figure 1). Given this exposure to so-called idiosyncratic (or specific) risk, the main thrust of diversification is simply to mix asset classes to attempt to mitigate the impact of any individual risk factor – or put another way, to diversify away as much risk as can be diversified away.

The great wisdom of Markowitz, stated simply, is that correlation matters. And given the relatively stark and simple separation of two major asset classes (stocks and bonds), along with their traditionally low correlation, the 60/40 portfolio simply emerged as the clearest expression of the theory. However, it is a shift in this specific relationship that has now led many to claim that the classic diversifying strategy is broken. But such a proclamation, we argue, completely misses the point. But that proclamation is also missing a key point.

Stocks and Bonds: An Odd Couple

Predicting stock price movements with any degree of precision is notoriously difficult, if not impossible. Even explaining after the fact why a particular stock or index moved can be difficult. However, explaining the theory behind why stock prices move is much easier – it generally comes down to either changes in earning expectations, changes in interest rates, or both. If we get bad news about earnings growth for a company, for example, the stock price is likely to fall. But the interest rate impact is a bit more complicated. At the most basic level, higher interest rates impact stocks in two ways:

1. They can make investments other than stocks (such as bonds) more competitive, thus making stocks less attractive.
2. They make future earnings and cash flows (dividends, for example) worth less today due simply to the higher discount rate (i.e., the rate used to estimate how much future growth is worth in today’s money to figure out what investors “require” to invest in stocks versus something else).

Both outcomes are obviously bad for stock prices.  Bond prices, however, are also intrinsically tied to interest rates. Higher rates make the value of existing bonds decline because future coupon payments are less valuable compared to new higher yielding bonds of the same quality. The dramatic volatility we see in markets, even with these rather obvious price movers, is explained by a nonstop flow of information that constantly shifts market expectations.

For our specific purpose, however, we care less about what causes stocks or bonds to move in any particular direction than how they move relative to each other given a particular market or economic change. But that introduces yet another surprising wrinkle: those relationships are as multifaceted and volatile as the individual prices themselves! Now, this may come as a surprise. In fact, most investors (laymen and professional asset managers alike) have long assumed that correlations are stable over time, or in the case of our 60/40 portfolio, that stocks and bonds are always inversely correlated (meaning that they move in different directions). This belief explains, at least partially, the bewildered reaction to the supposed paradigm shift that occurred in recent years when correlation turned positive and both stock and bond prices declined. That’s simply not supposed to happen.

But memory is an odd thing, and perspective is important. If we zoom out and look at periods before anything but the most recent historical timeframe (figure 2), we can see that, prior to 2000, the accepted “norm” was exactly the opposite! More interestingly, if we simply adjust how we measure correlation between stocks and bonds (say, by shifting a rolling measurement window), we see not only more variation, but considerably more time spent in positive territory, even over the past two decades. (figure 3).

This brings us to perhaps the most important point: there is no standard level of correlation between stocks and bonds that we can apply perpetually to portfolio analysis. This is because correlation is not an independent variable; rather, it is an observed metric that is entirely dependent on an ever-changing set of considerations. Everything from interest rate levels to stock market breadth (i.e., how many or few stocks are dominating markets) to which stock sectors are outperforming (say, when tech dominated during the dot-com boom and post-Covid) can lead to different correlation levels, not only between stocks and bonds, but between all asset classes.

Importantly, even interest rates changes, which we discussed above as a key shared driver of these prices (and which were blamed for 2022’s breakdown), do not have a stable impact on the stock/bond correlation. For example, rates could increase because of:

• better economic growth expectations that lead stocks higher and bonds lower, which is indicative of an inverse/negative correlation.
• something like an inflation shock (a la 2022), in which case both stocks and bonds can be impacted negatively, which is indicative of positive correlation.

This divergence can also occur when rates are falling. Rapidly falling growth expectations will lower rates and drag down earnings growth, which would typically be bad for stocks, but good for bonds. But rates could also fall on normalizing inflation expectations which are generally good for both stocks and bonds).

Research shows that the complex and sometimes counterintuitive correlation between stocks and bonds is both unstable and heavily dependent on the extremes of either very good or very bad market and economic environments.

Research shows that the complex and sometimes counterintuitive correlation between stocks and bonds is both unstable and heavily dependent on the extremes of either very good or very bad market and economic environments. But despite no “normal” level of correlation, the 60/40 portfolio has worked quite well in varying conditions over time (figure 4), meaning that such shifts do not make bonds ineffective, they just change the role that bonds play - sometimes acting as a hedging asset and other times as a so-called performing asset that is adding yield.

Going Beyond 60/40

However, arguing that the 60/40 model is not obsolete does not mean it is sufficient. It is often misrepresented that the 60/40 stock/bond portfolio was meant to be an ideal allocation for investors. We argue instead that it is more useful to frame the portfolio simply as a model – a way to put Markowitz into practice for the purpose of illustrating an important lesson: the future may be uncertain, but there are efficient ways to weather whatever may come.   

As an illustration, though, it is by definition incomplete, and the practical application of it is clearly not meant to be constrained to two asset classes. Indeed, the proliferation of investment funds that allow even retail investors to access nearly any type of company, regardless of industry or country, has made it easier than ever to go beyond the 60/40 portfolio. But while the easy access we now have to a wide array of global asset classes has dramatically changed the appearance of such an efficient portfolio, the core premise remains the same. 

The 60/40 portfolio gained prominence due to its strong risk/expected return balance (not to mention solid performance over time across multiple market cycles), but to oversimplify it as an ideal portfolio for every investor overlooks perhaps the most important rule of investing: optimal risk exposure should always be based on each individual investor, or more specifically, tied to their unique goals and timeline, which are key inputs in deciding how much risk a particular investor needs to take within a well-rounded financial plan.

Investing, unlike speculating, is done with intent!

Conclusion

The dramatic shift in 2022 that gained so much attention and led to a surfeit of articles about this exact topic is not usefully framed as a “break” from the norm, nor a change in the effectiveness of diversification.  If there is a lesson to be taken from the dramatic fall (and then recovery) of mixed portfolios like the 60/40 in recent years, it is simply that we shouldn’t expect any portfolio to excel in every market environment.

This also means that the most useful investment practices – the ones that worked when Markowitz wrote his essay – are not only the simplest, but evergreen.  And perhaps now, more than ever, given the elevated levels of complexity (better technology, more investment vehicles, and faster processing times), not to mention the heightened political, geopolitical, and economic uncertainty that we constantly face, the basics matter. Prudent diversification, correctly conceived as going beyond two asset classes and a set allocation, remains an effective way to invest in an uncertain future in the pursuit of financial security (figure 5).

So, keep to the basics. Stay diversified, focus on your specific portfolio needs, and stick to your financial plan. The spirit of the 60/40 portfolio lives through these actions and will continue to do so – at least until we learn to predict the future.

ⁱMarkowitz, H. (1952). Portfolio Selection. The Journal of Finance, 7(1), 77-91. 

The information in this report was prepared by John Weitzer, CFA, Chief Investment Officer, Matt Wiley, CFA, Vice President of Investment Management, and Matt Conner, Senior Investment Consultant of First Command. Opinions represent First Command’s opinion as of the date of this report and are for general informational purposes only and are not intended to predict or guarantee the future performance of any individual advisor. All statistics quoted are as of the date of this publication, unless otherwise noted. First Command does not undertake to advise you of any change in its opinions or the information contained in this report. This report is not intended to be a client specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Should you require investment advice, please consult with your financial advisor. Risk is inherent in the market. Past performance does not guarantee future results. Your investment may be worth more or less than its original cost. Your investment returns will be affected by investment expenses, fees, taxes and other costs.

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