The Wall Street Journal posted an interesting article yesterday – “The Trusted 60-40 Investing Strategy Just Had Its Worst Year in Generations” by Eric Wallerstein – that several Park Piedmont clients have already asked us about. Especially in this period of geopolitical turmoil and what appear to be fragile markets, we thought it would be helpful to consider the article in detail.
First, here’s some background on the “60-40” investing strategy:
As is typical in the financial world, when discussing portfolio allocations, the first figure represents stock holdings and the second stands for bond holdings. We often re-characterize stocks and bonds as “riskier/growth-oriented” and “less risky/income-oriented,” respectively, to make the unavoidable trade-off more explicit.
The article provides history:
“Investing in a mix of stocks and bonds is an idea rooted in the bedrock of Wall Street, the modern portfolio theory for which the late economist Harry Markowitz won the Nobel Prize in 1990. Among its biggest proponents: Vanguard founder John Bogle … [whose] aim wasn’t maximizing returns, it was allowing investors to sleep at night.”
(Park Piedmont note: John Bogle was a hero to our father Victor, who was an advocate of indexed investing and Vanguard mutual funds for about 50 years.)
In the broader financial community, the 60-40 portfolio has functioned as a rough guideline for investors. This is especially true for 401K plan participants who don’t have a specific idea of how they should be investing retirement funds.
The good idea here is that investors should own a mix of stocks and bonds, which often, although not always, perform differently in different market environments. A prominent example was the financial crisis of 2007-2009, when bond returns were positive while the S&P 500 index declined 45% in the same period.
In 2022, however, “the tried-and-true 60-40 portfolio lost 17% … its worst performance since at least 1937 … Even with a 14% gain in the S&P 500 helping the strategy recover in 2023, stocks and bonds have moved in tandem, more over the past three years than any time since 1997.”
The problem with 60-40 is that it’s a one-size-fits-all investing approach. A 60% allocation is likely too low for a 25-year-old just starting their career, while it may be too high for a 65-year-old on the verge of retirement.
As our clients know, Park Piedmont spends significant time working with you to develop an allocation appropriate to your situation. We don’t recommend changing the allocation in the context of short-term market declines; we refer to this as “market timing,” which typically involves selling the declining asset and/or buying the rising asset.
We do, on the other hand, advocate for re-balancing, or buying the declining asset at lower prices and potentially selling the rising asset as well. We also work with clients to adjust allocations when their life circumstances change significantly, due to the birth of child, divorce, or death of a spouse, for example.
For these reasons, the success or failure of the standard 60-40 portfolio isn’t really an issue for Park Piedmont clients, all of whom have customized allocations.
But what concerns us about the rest of the article are some of the conclusions drawn and especially the investing alternatives mentioned, along with the attempt by some financial firms to portray inherently risky (and often expensive) strategies as less risky or even safe.
The article goes on: “Some analysts say the crux of the [60-40] portfolio’s success—bonds’ tendency to rise when stocks fall—generally happens when inflation and interest rates are relatively low. They argue that expectations for a prolonged period of higher rates and lingering inflation will weigh on both stocks and bonds, fostering a market environment that looks much different than in recent decades.”
There are many factors responsible for stock and bond prices moving in the same direction, just as there are when they move in opposite directions. But these trends typically vary over time, as the first chart in the WSJ article shows, and market returns have been good and bad in both periods. There’s simply no way to predict how markets will react whether stocks and bonds move in tandem or not.
We tend to agree with Roger Aliaga-Diaz, global head of portfolio construction at Vanguard, who Wallerstein quotes as saying that “the problem isn’t higher rates, it is when they are rising rapidly like in 2022 … The central bank hiked rates 11 times since March 2022, the fastest pace in four decades, bringing them to a 22-year high. A gentle climb in Treasury yields can reflect a healthy economy and provide investors with more income. But when rates rise rapidly, it can destabilize markets, giving companies little time to adjust to elevated borrowing costs and spurring investors to rethink the value of stocks.”
Wallerstein then mentions alternative investing strategies. “Some financial advisers suggest being more deliberate about specific stock-and-bond holdings.” Picking individual stocks and bonds is referred to as “active management” in the financial advisory business and has historically been as difficult to do well over long periods as market timing has been.
“Others recommend looking beyond stocks and bonds altogether to more complex investments, often ones that are riskier and charge higher fees. Real estate has long been a popular option for individuals with some spare cash. Some advisers have suggested adding exposure to commodities or corporate loans.”
Park Piedmont doesn’t oppose investments like these, and in fact includes small allocations to real estate (through real estate investment trusts, or REITs), commodities, and corporate loans in lower-cost funds. The distinction is that we include them in broadly-diversified, long-term-oriented portfolios, not attempts to predict whether they will perform well over some short timeframe. We also label them as riskier assets, making no attempt to portray them as less risky in certain market environments.
“Another popular twist is the risk-parity portfolio. The strategy … tweaks its stock-and-bond holdings based on how volatile each asset has been recently, putting more cash toward whichever one is less erratic. The idea is that the asset that is less volatile is therefore less risky, and should be a better bet going forward. That approach still struggled during last year’s lockstep moves in stocks and bonds.” Wallerstein’s last sentence in this section makes our point for us.
Finally, the article mentions that “many hedge-fund strategies have performed unevenly since 2008 … [but] managers of these funds say their benefits will be starker as markets become more turbulent.” [Park Piedmont note: Hedge funds started as an effort to reduce portfolio risk, but in many cases have morphed into massively risky bets.]
Our final point is that many of these alternatives come with very high expenses; hedge funds often charge 2% annual management fees in addition to taking 20% of any gains investors earn. While investors can’t control market returns, they can control the cost of their investments, which is one of the reasons why PPA primarily uses low-cost index funds to implement client allocations.
So there’s no need to bemoan the recent challenges to the 60-40 portfolio. Except for people who had every dollar in cash last year, all portfolios declined in 2022. But that’s no reason to abandon a well-diversified, low-cost portfolio designed to accomplish your long-term financial goals, which is what we at Park Piedmont focus on every day.