The 60/40 Strategy Portfolio – Is It Dead? (Backtests, Alternatives, And Substitutes)
Last Updated on February 9, 2023
Determining the right mix of assets to help you reach your short-term and long-term financial goals is the key to building a winning investment portfolio. For many years, financial advisors and experts recommend the 60/40 portfolio because of its simplicity and favorable risk-adjusted returns. But given the changing economic situations in 2022 and the 60/40 portfolio’s 16.1% decline in the first half of the year 2022, one might wonder whether the 60/40 portfolio is out of season or simply dead! Are you wondering what the 60/40 portfolio strategy is?
The 60/40 portfolio strategy is one that allocates 60% of capital to equities and 40% to bonds. It consists of a diversified portfolio of stocks and bonds. In its simplest form, it could be achieved by investing in the S&P 500 ETF and U.S. Treasuries, which give a US-only portfolio.
However, by including international stocks and bonds, one can construct a globally diversified 60/40 portfolio.
In this post, we take a look at the 60/40 portfolio and its performance, and at the end of the article, we look at ways you can improve the 60/40 strategy.
What is the 60/40 portfolio?
The 60/40 portfolio is one that allocates 60% of capital to equities and 40% to bonds. It consists of a diversified portfolio of stocks and bonds. In its simplest form, it could be achieved by investing in the S&P 500 ETF and U.S. Treasuries. But that would mean having your entire portfolio in US-based investments. By including international stocks and bonds, you can construct a globally diversified 60/40 portfolio.
While the balance of this 60/40 mix can be adjusted based on an investor’s time horizon, risk tolerance, and financial goals, its stock-bond combination remains the same, which is why it is considered a “diversified” portfolio.
60/40 portfolio and correlation
The model works because stocks and bonds tend not to correlate most of the time. Usually, when growth assets, like stocks, sell off due to economic slowdowns, safer assets like bonds appreciate as investors seek stability. Stocks tend to suffer in a recession due to less economic growth, while bonds can rally because the U.S. Federal Reserve typically cuts interest rates to support the economy.
Here is how: when interest rates are cut, bond yields drop but bond prices go up. The rise in bond prices provides helps to cushion overall returns when stocks are falling. To better understand this relationship, please read our previous articles on the topic:
In theory, the 60/40 portfolio provides adequate diversification that allows you to maintain balance in your portfolio when the market is high and when it’s low. By allocating a sizeable portion to bonds, the model is designed to minimize risk while generating a consistent rate of return over time, even during periods of equity market volatility.
The key is correlation, or perhaps more precisely, non-correlation. Below is a plot of the 200-day correlation between S&P 500 and Treasury bonds.
As you can see, in times of turbulence in the stock market (marked by blue circles) correlation has tended to be low or negative (Treasuries/bonds outperforming stocks). However, in 2022 this has not been the case:
During the financial crisis in 2008/09, in 2015, and during the covid mess in 2020, bonds functioned as a safe haven and reduced the losses from stocks – exactly as it was supposed to do. But this has come to a grinding halt so far in 2022. As a matter of fact, “safe” Treasuries have fallen more than stocks!
Please keep in mind that this is not the first time BOTH stocks and bonds go down. The table below is provided by Blackrock and shows the performance between stocks and bonds:
The table above shows that 2022 is not a complete outlier: it has happened before, but not frequently!
What is the key lesson from this, according to Blackrock? This is their conclusion:
The key lesson: Bonds may be a reliable diversifier when economic growth is slowing – but not necessarily when inflation is increasing.Blackrock
2022 is indeed a year when inflation is picking up – a lot – and thus bonds are not a safe haven.
Because the principles of correlation are so important in investing and trading we recommend you have a look at the articles we have written about them:
- What does correlation mean in trading?
- Uncorrelated assets and strategies – benefits and advantages
- Does your trading strategy complement your portfolio of strategies?
- Why build a portfolio of quantified strategies
How to build a 60/40 portfolio/strategy
As a DIY investor who wants a self-directed investment, the easiest way to construct a 60/40 portfolio is by investing in low-cost exchange-traded funds (ETFs) that track broad market equity indexes and investing in bond funds. This could be SPY (S&P 500) and TLT (long-term Treasuries). These two can easily be rebalanced 1-4 times per year at minimal costs. Another option is VTI (US large cap) and BND (US bonds).
Alternatively, you can invest in an already-prepared 60/40 fund, such as the BlackRock Target Allocation Funds (more later). Building a 60/40 portfolio by investing in individual stocks and bonds would be very expensive and is not recommended.
60/40 portfolio historical performance (annual returns)
According to money manager Vanguard, the historical annual return of the 60/40 portfolio has been an impressive 8.8% since 1926.
Below is a table made by the investment bank JP Morgan that shows the returns each year from 1980:
The risk-reward has been pretty impressive: the drawdowns have been mild while returns are pretty stable and high. The interest rates peaked in the early 80s and this has been a major tailwind for the portfolio.
After drawdowns or weak annual returns, the future average returns are higher: periods of negative returns must be followed by years with higher-than-average returns. We are not believers in market timing (market timing is extremely difficult) and market timing is doomed to fail as a strategy. This means that the best strategy is to stay in the game and ride out the volatility swings.
60/40 portfolio performance 2022
Let’s look at the 60/40 portfolio for 2022 in more detail. Many investors are worried we are witnessing the strategy being broken. Such discussions always happen after a drawdown – obviously not after when times are good and stocks going up.
The performance of the 60/40 portfolio has varied over the years. According to Portfolios Lab, as of Sep 17, 2022, the 60/40 portfolio returned a negative 17.77% year-to-date and 9.11% of annualized return in the last 10 years.
A $10,000 invested in the 60/40 Portfolio in Jan 2010 would now be worth nearly $28,011 for a total return of roughly 180.11% — all prices are adjusted for splits and dividends, and the portfolio is rebalanced quarterly:
When compared to the S&P 500 index or another benchmark, here is what it looks like:
Even after the disastrous year in 2022, we see that the 60/40 portfolio is still ahead of the S&P 500!
60/40 portfolio dividend yield
The 60/40 Portfolio offered a 1.89% dividend yield in the last twelve months.
60/40 portfolio Sharpe Ratio
As of writing, the current Sharpe ratio of the 60/40 Portfolio is -0.76. What this means is that the risk-free rate is higher than the portfolio’s return. The chart below displays the rolling 12-month Sharpe Ratio.
60/40 portfolio drawdowns
Sadly, drawdowns (what is a good drawdown percentage?) are what make investors and traders give up. It’s easy to give up and fold when the markets are tough. Unfortunately, that is normally the wrong thing to do. As Charlie Munger once said: if you can’t handle a 50% drawdown, you should not invest in the first place.
Because of this, let’s have a look at what you can expect in terms of drawdowns with the 60-40 portfolio:
The 60/40 portfolio worst drawdowns
The table below shows the maximum drawdowns of the stocks/bonds 60/40 portfolio since the financial crisis in 2008/09. This is an indicator of risk that shows a reduction in portfolio value from its maximum due to a series of losing trades.
The maximum drawdown since January 2010 for the stocks/bonds 60/40 Portfolio is 21.85%, recorded on Mar 23, 2020. That drawdown took 79 trading sessions for the portfolio to recover.
60/40 portfolio intra-year declines vs. calendar year returns
If we look at a longer time span we revert to the following table showing both the annual returns and the max annual drawdowns:
From the chart above, we can see that despite average intra-year drawdowns of -7.7%, annual returns were positive in 35 of 42 years.
60/40 portfolio volatility
The current volatility of the 60/40 portfolio strategy, as of writing, is 7.07%. Volatility is a statistical measure showing how big price swings are in either direction — the higher the volatility in an asset, the riskier it is, as price movements become less predictable.
The chart below shows the rolling 10-day volatility.
60/40 portfolio fund
A 60/40 fund is a managed fund that invests in a diversified 60/40 portfolio. It presents an easy way to have a 60/40 portfolio.
A typical example of a 60/40 fund is the BlackRock Target Allocation Funds, which offer investors a ready-made way to balance their investing outcome through diversification across active and index, stocks, and bonds using a suite of underlying mutual funds and ETFs. It provides a balanced and diversified exposure across a wide range of asset classes, geographies, and securities.
The breakdown of the fund’s capital allocation can be seen in the charts below:
60/40 portfolio ETFs
iShares Core Growth Allocation ETF (AOR) is one such ETF. The prospectus says the equity allocation is between 50-70%, but we believe it’s mostly around 60%.
Is the 60/40 portfolio dead? Is the portfolio in danger?
As of Sep 17, 2022, the Stocks/Bonds 60/40 portfolio returned a negative 17.77% year-to-date, and this has prompted the question:
Is the 60/40 portfolio dead? Is the portfolio in danger of becoming obsolete and useless? Typically, this is a question that pops up after a bad performance.
Given the current low-yield environment, many are questioning the merit of a diversified portfolio of traditional equities and bonds when yields are still relatively low and might lead to further future losses in bonds.
This is a fundamental question in the way investors view and manage risks: Is there still a role for traditional diversifiers, such as bonds, in today’s balanced portfolio, given that we are expecting this yield volatility to continue for years to come?
No doubt returns this year have been unsettling, but a double-digit decline in the 60/40 portfolio is not unheard of, as we have already pointed out in this article. In fact, since 1980, there have been nine instances in which the 60/40 fell more than 10% within a given year.
In those instances, investors who were patient with their portfolios were often rewarded with a rebound. In fact, in five of those years, returns still ended the year with positive values, while in eight of the nine instances, returns the following calendar year were positive — an average return of over 17%. As a general rule, you get rewarded by taking risks in financial markets (over the long term).
So, while the situation in 2022 is concerning, the 60/40 portfolio is not dead. We still believe it is based on solid principles of diversification to reduce risks. We think that the problem here is the unrealistic expectations of returns from a well-diversified portfolio given current market conditions. But this present market situation is not out of place, as downward pressure on inflation and unprecedented levels of central bank stimulus have seen 10-year government bond yields fall from 5% to just 1.6% over the past decade. On the other hand, the huge performance of stocks over this same period cannot last forever.
Stocks may face additional headwinds as earnings expectations are revised down. With the Fed aggressively raising rates to tame inflation, the near-term environment for stocks and bonds could continue to be challenging. However, it is likely that most if not all of the Fed rate hiking cycle will be over by 2023 at most. Nonetheless, bonds have struggled while rates have risen. As investor concerns shift to slowing growth, there is scope for yields to fall.
Although it has been a painful ride down, the situation might create an opportunity for subsequent returns. Looking at a valuation measure of the 60/40 portfolio based on blending the earnings yield on stocks and the yield-to-worst on bonds (higher = less expensive), valuations have become much cheaper — from 3.5% to start the year to 5.3% at the end of Q2. These lower starting valuations would mean an average annualized return over the next decade of 6.1%, which is a lot better than the 2.6% to start the year. It may be smart for investors to shift their focus to where returns could be going in the months and years ahead, rather than what is happening now.
Admittedly, the outlook for both equities and bonds is likely lower for some time, but that doesn’t invalidate the principles of diversification by allocating capital to high-quality government and corporate bonds along with equities.
60/40 vs 80/20 portfolio
An alternative to the 60/40 portfolio is the 80/20 portfolio. What is the 80/20 portfolio?
The 80/20 portfolio the same strategy but with different weightings: 80% to equities and 20% to bonds. The logic is that you should have a higher weighting on equities because of potentially higher futures returns (equities show historically higher returns than bonds – as it should due to higher risk).
Because of the weak bond market, the 80/20 portfolio has gained interest. Typically this happens AFTER both stocks and bonds are weak at the same time.
60/40 portfolio alternatives and substitutes (6 options to 60/40)
One of the aims of an investor is to have smooth returns while not necessarily lowering returns. the 60/40 portfolio is, of course, not the only way to achieve proper diversification in the market. As a matter of fact, we believe it’s a suboptimal way of getting diversification. The 60/40 strategy is easy to implement but so are the other alternatives.
Let’s look at some alternatives or substitutes to the 60/40 strategy:
60/40 portfolio alternative no 1: the All-Weather Portfolio
Ray Dalio is the manager of the world’s biggest hedge fund, Bridgewater Associates, and has for years advocated what he calls the All-Weather Portfolio. Because we have already covered his portfolio in detail we only provide you with a link to the article:
The portfolio is an example of how you can diversify better than the classical 60/40 portfolio.
60/40 portfolio alternative no 2: trend-following (CTA strategies)
A trend following strategy normally adds a lot of diversification. The reason is simple: in times of crisis, prices tend to go up or down – a lot. Because of this, trend following (or CTA strategy) is our favorite diversification tool.
Trend following doesn’t involve market timing or tactical asset allocation, it just reacts to prices moving up or down. Additionally, we believe trend-following strategies are good to offset tail risk.
Let’s do a backtest where we throw in another ETF to our portfolio mix: KMLM (in addition to SPY and TLT).
KMLM tracks a basket of commodities by using a very simple indicator: The 200-day moving average. The index KMLM tracks is called MLM – Mt. Lucas Management Index. 25 commodities are tracked by using a moving average crossover strategy for the commodities (equally weighted). Long positions are taken when the price is above the moving average, and the opposite, a short position is initiated when the price is below the moving average. It can’t get any simpler than that!
We make the following trading rules:
- SPY has a 60% weighting
- TLT has a 20% weighting
- KMLM has a 20 weighting
In our backtest we rebalance daily. The result doesn’t differ much no matter how often you rebalance the assets.
KMLM was floated as late as the end of 2021 so its history is short. However, we have written more about the history of the index in our article Do Trend Following Trading Strategies Work?.
The equity curves for the original 60/40 portfolio, our new portfolio, and S&P 500 look like this:
The chart above shows our backtest of the three portfolios from 2021 until today. The best performance is the 60/20/20 portfolio (blue line), the second best is S&P 500 (black line), and the worst is 60/40 (red line). S&P 500 has performed well because of a very good 2021. But as you can see, KMLM has so far 2022 recouped all the losses in our original 60/40 allocation. Trend-following strategies have had a spectacularly good year in 2022.
60/40 portfolio alternative no 3: add gold
Gold acts in many ways the same as stocks: it gradually increases in price and serves as a long-term inflation hedge. At the same time gold, most of the time, correlates little with the US stock market, thus making it useful for portfolios.
60/40 portfolio alternative no 4: add crypto
Crypto still is in its early stages and has a lot to prove. However, most people are either strongly for crypto or strongly against it. But you might take a middle ground. We have no idea what allocation is best for crypto, but we believe it might deserve a small allocation like 1-2%.
This is a small allocation. But if crypto turns out to be a big win, you are still in. If it fails, you only suffer a small loss.
One drawback with crypto (at least today) is that this is a risk on and off asset that tends to move in tandem with the overall market.
60/40 portfolio alternative no 5: add international equity markets
On any random day to day all international equity markets tend to correlate strongly. But if you widen the time horizon you’ll discover that equity markets go their own directions (but still most of the time up). This is great and you add diversification by spreading a few of your eggs in some international markets.
60/40 portfolio alternative no 6: add tail risk strategies
Nassim Taleb was one of the first to mention tail risk strategies (what is tail risk hedging strategies?). Together with his partner Mark Spitznagel they developed ways to mitigate risk but at the same time increase expected returns.
That said, normally a tail risk strategy means less returns because it’s a drag on performance. Because we have already backtested such strategies, we strongly recommend reading our results:
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The 60/40 portfolio strategy – ending remarks
To make a positive return in the long run you need to take risks. Bonds have been troublesome so far in 2022 (to put it mildly) but we see no reason to abandon the 60/40 portfolio. It has had very bad years before and recovered. No one knows, of course, if both bonds and stocks will continue lower, but we believe market timing is futile.
An alternative to the 60/40 portfolio is to add other asset classes. In this article, we added trend-following, and this has served the portfolio very well. Trend-following has different return distributions than stocks and bonds and thus might serve as a useful hedge and diversification.