60/40 Investment Strategy: Why We Should Not Abandon It

Feb 23, 2023

Two thousand twenty-two will be a year to remember after many events that shook the financial world. The U.S. markets experiences historic losses while the Federal Reserve tried combat record-high inflation, they raised interest rates at an unprecedented rate, the cryptocurrency market took a hit with the fallout of FTX, and much more.[1] Additionally, in 2022 60/40 portfolios had one of their worst years yet, due to bonds having one of their worst years in history, and the worst combined total return for both stocks and bonds dating back to 1872.[2]

A 60/40 portfolio, the commonly used allocation for retirees, refers to an investment portfolio that is allocated 60% to stocks and 40% to bonds. The goal is to have a balance between risk and reward, as stocks tend to be riskier, but have the potential for higher returns, while bonds are considered less risky and have lower returns. The purpose of this allocation is to provide a level of stability and income while still allowing for potential growth. The reason for the popularity and usage of 60/40 can be tied to their historical inverse relationship between stock and bonds, in that while stocks are generally more volatile, bonds have shown to go up or at least remain flat during these turbulent times.[3] This diversification providing a desired level of security.

Historically, a 60/40 portfolio has had an average annual return of around 8.8%, from January 1, 1926, to December 31, 2021.[4] The amount of money a 60/40 portfolio can make for an investor over time depends on several factors, including the performance of the stock and bond markets, the individual’s investment horizon, and the specific stocks and bonds included in the portfolio. It is worth noting that past performance is not indicative of future results, and the returns on a 60/40 portfolio can vary greatly depending on market conditions, like we have seen in 2022.

A typical 60/40 portfolio lost about 15% last year, if the bonds were long term than the losses were greater.[5] Long-term bonds are more sensitive to changes in interest rates than short-term bonds, as the bond’s price can fluctuate greatly if the market interest rate changes. Last year, bonds lost 13%, with long-term treasury’s slumping more than 29%, and in comparison, the S&P fell 18%.[6]

So, why did bonds do so badly in 2022? The interest rates were a big factor. Interest rates and bond prices have an inverse relationship, meaning that when interest rates rise, bond prices fall, and when interest rates fall, bond prices rise. This is because bonds pay a fixed rate of interest to investors, and when market interest rates are higher than the rate paid on a bond, the bond becomes less attractive to investors, causing its price to fall. Conversely, when market interest rates are lower than the rate paid on a bond, the bond becomes more attractive to investors, causing its price to rise.

While this past year was a bad year, 60/40 portfolios still are a great investment plan for many, and we shouldn’t discredit them. To put last year into historical perspective, according to T. Rowe Price Investment Group, the extreme loss that 60/40 portfolios were hit has a probability of occurring once in every 130 years.[7] If we look at the history of the 60/40 portfolio, we see that since 1980, there have been nine instances in which the 60/40 fell more than 10% within a given year. In five of those years, returns still ended the year positive. In eight of the nine instances, returns the following calendar year were positive, with an average return of over 17%.[8] This shows that 60/40 portfolios investors who are patient with their portfolios can see a rebound and returns. Additionally, years that both stocks and bonds declined, while rare, they typically followed by a sharp rebound (see chart below).[9]