Scepticism surrounding the merits of the traditional 60/40 asset allocation approach has become a key point of contention among investment professionals over the past decade, with market movements in recent years leaving investors wondering whether the long-established relationships between traditional asset classes still hold. We wade into the debate, explaining why we think the simplistic approach no longer holds up in modern day investing.
The Traditional Approach
Within a traditional 60/40 model portfolio, 60% of the portfolio allocation is made up of higher risk assets, such as equities, while 40% is to lower-risk assets, such as bonds. This approach aims to deliver equity-fuelled growth alongside fixed income stability, which should help smooth portfolio performance across different market conditions throughout the economic cycle, for investors with a balanced risk profile. In the past, this approach has produced the desired outcomes. On a backwards looking basis, a 60/40 portfolio allocation produced an annualised return of 7.43% over the last 20 years between 2002 and 2021*, a return profile that many investors would be satisfied with for less volatility than riskier investment portfolios. However, investment professionals have increasingly argued against the 60/40 portfolio given changing market conditions over the past ten years, suggesting that evidence that bonds move in an opposite direction to equities in volatile market conditions has become much less convincing.
Why Return Expectations Have Changed
As of writing, the US and UK 10-year government bonds are yielding 1.773% and 1.272%, respectively (as at 02/02/2022). Historically, the return of US 10-year government bonds reached a high of 15.84% in 1981, alongside yielding 9.50% by the end of the 1980s. This drop off in yields can be explained by the weakening inflation environment and low level of interest rates in recent years. For example, discrete annual inflation rates have failed to exceed 4% within the US and UK between 1993 to 2020. In addition, interest rates have remained close to their zero lower bound for much of the past decade. Due to this, the return profile provided by the 40% bond allocation is considerably lower than had been achieved historically, leading to JPMorgan’s Chief Global Strategist expecting a 40% US bond allocation to net an annual return of just 4.20% over the next 10 to 15 years.
The 60% equity allocation is also questionable. Within the US, while investor portfolios have been heavily reliant on the region’s equities for outperformance in the past, US large-cap equity valuations are currently near their 97th historical percentile, making them susceptible to downward price pressures today and in the future. The only other time US large caps were this expensive had been during the dot com bubble in the early 2000s. Expectations are that US equities are likely to underperform those in the Europe and UK over 2022-2023 in the current market environment, suggesting the traditional global exposure is likely to come under strain against more actively managed exposure in the years ahead.
Our View on the 60/40 Portfolio Allocation
Despite the rise in inflationary pressures over the past 12 months, with interest rates forecasted to only rise over the coming years, it is our view that investors can no longer rely on a traditional 60/40 portfolio allocation to yield meaningful portfolio returns. While we do not think the 60/40 portfolio is completely dead, we do believe that investors increasingly have to look beyond their traditional regional and sector allocations. Opportunities within small caps, property, private assets, emerging markets, inflation-linked instruments, as well as thematics, could all act as appropriate alternatives to improve return prospects and manage risks over the coming years, and should be considered within a well-diversified portfolio to successfully navigate markets in the years ahead.
Ben Pickles| Global Macroeconomic Analyst
*Source: FE Analytics, based on a 60% allocation to a Global Index and 40% allocation to a Sterling Aggregate Corporate Index, rebalanced on a quarterly basis, in GBP.
Past performance cannot be used as a guide to future performance and the value of your investment will fall as well as rise in value. You may not get back all of your investment and the final value of your investment will depend on the performance of your portfolio. The actual performance of an individual client’s portfolio may differ due to different funds being used and being restricted in relation to certain asset allocations. Performance figures quoted include fund manager charges but exclude adviser, discretionary, custodian and switch charges. Unless stated, income is reinvested into the portfolio. The information contained in in this document is for information purposes only. It does not constitute advice or a recommendation or an offer or solicitation for investment.