60/40 Portfolio: the Foundation of Asset Allocation

Introduction: 60/40 Portfolio

Among investment portfolios, perhaps the most well-known and commonly used is the 60/40 strategy. This is a simple portfolio consisting of 60% stocks and 40% bonds. The idea is to combine the relatively high returns and volatility of stocks with the relatively lower returns and volatility of bonds, creating a balanced portfolio with moderate returns and reduced volatility. Of course, other combinations are possible; if you desire higher returns, you may increase the stock ratio to 80/20 or 90/10, or if you want lower volatility, you may reverse the ratio to 40/60 or 30/70.

Instead of just saying "always invest in a 60/40 ratio", the financial industry has come up with the "100 minus age" rule. For example, if you are 35 years old, you would allocate 65% to stocks and 35% to bonds. As you age, the proportion of stocks decreases, and the bond allocation increases. Depending on an investor's risk appetite, the rule can be modified to "110 minus age" or "120 minus age."

ETF Composition

Since the portfolio is quite simple, let’s skip the pie chart and move straight to a table. The 60% stock portion consists of VTI (Vanguard Total Market ETF) and the remaining 40% bond portion is made up of BND (Vanguard Total Bond Market). If you prefer the S&P 500 index, you can use SPLG (SPDR Portfolio S&P 500 ETF) or IVV (iShares Core S&P 500 ETF) instead of VTI. This is because the S&P 500 accounts for approximately 87% of the total U.S. stock market as of Sep 2024.

If you prefer global assets rather than just U.S. exposure, you can substitute VTI with VT (Vanguard Total World Stock ETF, which, as of September 17, 2024, consists of 64.9% North America, 17.5% Asia, 15.4% Europe, and 2.3% other regions) and replace BND with BNDW (Vanguard Total World Bond ETF, which includes only investment-grade bonds like BND).

If you're not keen on periodically rebalancing this two-ETF portfolio, you could simply buy the VSMGX (Vanguard LifeStrategy Moderate Growth Fund), which automatically follows the 60/40 portfolio. For a more aggressive 80/20 strategy, you could opt for the VASGX (Vanguard LifeStrategy Growth Fund). But just note that these are mutual funds, not ETFs.

Historical Performance

Source: www.lazyportfolioetf.com

(Rebalancing on January 1st each year. Dividends are reinvested. Fees and capital gains taxes are assumed to be zero. Maximum period: January 1, 1871 – August 31, 2024)

With a 12.2% return year-to-date through August 2024 and 18.7% over the past 12 months, these returns are certainly appealing. When looking at the past 10 years, the average annual return was a respectable 8.2%. Over the past 154 years, the average return has been 7.7% (one of the perks of the long history of capital markets in the U.S. is having access to such long-term data). The table also shows inflation-adjusted returns, with the lowest figure being 4.8% over the past five years, and long-term returns close to 5.5%.

Maximum Drawdowns

Source: www.lazyportfolioetf.com

The chart above shows the maximum drawdowns of the 60/40 portfolio over the last 55 years, starting from 1970. The worst drawdown was -30.6% in 2009, a reminder of the devastating impact of the Global Financial Crisis. The second worst drawdown was -27.3% in 1974, during a time of soaring inflation due to the Vietnam War, the 1973 Yom Kippur War in the Middle East, and the ensuing oil shock. Given the circumstances, a 27.3% loss wasn’t too bad. More recently, the portfolio suffered a drawdown of -20.7% in 2022, driven by the Fed's rapid rate hikes, which caused simultaneous declines in both stocks and bonds.

Backgrounds

Creator: Unknown. Some claim the concept originated with Harry Markowitz, who won a Nobel Prize for developing Modern Portfolio Theory. However, this kind of asset allocation existed long before, so the creator remains anonymous in my opinion.

Logic: The combination of stocks and bonds is intended to create a portfolio that offers higher returns than bonds but with lower risk than stocks. Conversely, this means accepting lower returns than stocks but with higher risk than bonds.  Let's break it down simply:

• Slowing economy → Stock prices fall / Inflation decreases → Interest rates fall → Bond prices rise
• Strong economy → Stock prices rise / Inflation increases → Interest rates rise → Bond prices fall

When both stocks and bonds have positive returns but are negatively correlated, combining the two can generate decent returns with reduced volatility. Thus, the 60/40 portfolio was born, with a slight emphasis on stocks for better returns.

My Thoughts

Historically, investors have employed a mix of risky and safe investments to build and preserve their wealth, with stocks and bonds being the most common combination in today's capitalist world. While bank savings or real estate can replace bonds, they either don’t offer as high returns (bank savings) or lack liquidity (real estate), though they may be safer (bank savings) or provide higher returns (real estate) than bonds.

Is the logic behind the 60/40 portfolio - stocks and bonds typically moving in opposite directions - generally reliable? What happens if their correlation turns positive, meaning they rise or fall together? Let’s consider the following:

• Rising inflation → Fed raises interest rates → Bond prices fall and stock market declines
• Falling inflation → Fed cuts interest rates → Bond prices rise and stock market gains.

If stocks and bonds move together, their combination can actually increase volatility. The worst-case drawdowns in 1974 and 2022 were examples of this, where both stocks and bonds fell simultaneously. Instead of offsetting the decline in stock returns, bonds actually exacerbated it. The graph below, created by Morgan Stanley, shows the correlation between US stocks and bonds from the late 1800s to the present. When the line on the graph is above 0, stocks and bonds move in the same direction; when it's below 0, they move in opposite directions. It's evident at a glance that the positive correlation was more common.

Source: www.morganstanley.com/im/publication/insights/articles/article_bigpicturereturnofthe6040_ltr.pdf

So, when do stocks and bonds move in the same direction, and when do they move in opposite directions? According to the chart below, when inflation exceeded 2.4%, the correlation between stocks and bonds became positive. However, under normal inflation rates (0.9% to 2.4%), the correlation was negative. When inflation fell below 0.9%, the correlation became positive again. So, the underlying  implicit assumption of the 60/40 portfolio is not always accurate.

Source: www.morganstanley.com/im/publication/insights/articles/article_bigpicturereturnofthe6040_ltr.pdf

When analyzing a portfolio's risk and return, people often use metrics like the Sharpe ratio or Sortino ratio. However, I don't rely heavily on these numbers. Here's why. As shown in the table below, the Sharpe ratio of a 60/40 portfolio fluctuated significantly from an average of 0.05 over the past three years to 1.19 over the past year. The Sortino ratio also fluctuated wildly between 0.07 and 1.59. While these numbers tend to stabilize over the long term, they provide little insight into the potential returns and maximum losses of your portfolio in the coming year or two, which is what really matters for your investment psychology. That's why I tend to separately consider whether the portfolio's long-term returns are close to my target and whether I can tolerate its historical maximum drawdown.

The 60/40 portfolio's average annual return over the past 30 years was 8.5%, slightly higher than the All-Weather Portfolio's 7.7%. However, the maximum drawdown over the past 55 years was -30.6% (in Feb 2009), significantly worse than All- Weather's -20.6% (in Sep 2022). As the saying goes, there is no free lunch.

Conclusion

The 60/40 portfolio is likely one of the oldest and most widely used investment strategies. TDFs (Target Dated Funds), commonly found in retirement accounts, are essentially variations of the 60/40 portfolio.

During periods of stable inflation, stocks and bonds moved in opposite directions, enhancing the 60/40 portfolio's performance. However, when inflation exceeded 2.4%, the portfolio underperformed as both stocks and bonds tended to decline together. Therefore, investors in this portfolio should be cautious when inflation rises.

Let's compare it to the All-Weather portfolio. As a reminder, the All-Weather portfolio consists of stocks (30%), bonds (55%), gold (7.5%), and commodities (7.5%). The 60/40 portfolio has double the stock allocation, resulting in relatively higher returns and volatility. The All-Weather includes gold and commodities to hedge against high inflation, while the 60/40 portfolio lacks such protection.

In conclusion, the 60/40 portfolio is more suited for investors who seek higher returns and can tolerate greater volatility compared to those following the All-Weather portfolio. However, what if an investor is not satisfied with its long-term annual return of about 7.7%? Alternative investment strategies with higher potential returns will be explored in future articles.

Thanks for reading. I wish you success in making smart investments!

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