Don’t Let 2022 Fool You: A 60/40 Portfolio Still Offers Real Value

Time tested or out of touch? That’s the debate swirling around the long-held belief that a so-called 60/40 portfolio—with 60 percent of assets held in equities and 40 percent invested in fixed income—is a sound strategy that should meet the long-term needs of most investors. While detractors of the strategy have cropped up from time to time over the past several years, the chorus of naysayers grew louder last year as bonds faltered in the face of aggressive interest rate hikes by the Federal Reserve Board and failed to offset losses among equities.  

Famed investment researcher Harry Markowitz is credited with proposing the value of a 60/40 portfolio as a foundation for a sound investment strategy in an essay published in 1952. Little could he have imagined back then the significant changes the investment world would see in the subsequent 70 years. Given the differences, it’s worth asking, “Is the 60/40 and its underlying logic dead?” We don’t think so. Instead, as the investing landscape has evolved, we believe today’s investment opportunities still fit within the spirit of the 60/40 portfolio and can enhance the soundness of the approach.  

Putting recent performance into perspective  

Last year’s simultaneous poor showing for equities and fixed income was a rarity (as you can see in the chart below), marking only the fifth time since 1926 that both asset classes posted negative performance in the same calendar year. In four of the five instances, the common denominator for the poor showing was an economic backdrop that featured inflation above 5 percent. History has shown that negative performance by both asset classes is an anomaly. Despite the unusual losses, some investors suggest it is evidence that the world has changed significantly from the introduction of the 60/40 concept and that a more diverse and complicated investment landscape calls for scrapping the seemingly simplistic approach.  

Those arguing against the strategy cite the nearly 40-year steady decline in interest rates that in recent years resulted in bonds offering modest or in some cases negative yields when adjusted for inflation. However, that argument is undercut on two fronts: First, interest rates are tied to future expectations for the economy and tend to move in the same direction as inflation. As a result, yields have risen, and fixed income now offers positive inflation-adjusted return opportunities. Second, the role of fixed income in a portfolio is broader than yields or income. In addition to offering regular coupon payments, fixed income helps secure liquidity and hedge risks. With inflation easing and bond yields now around 5 percent, well above historic lows, bonds have returned to their historical role of offering real value and a hedge against equity downside movements. 

Put simply, we don’t believe the struggles encountered last year should distract investors from the three roles bonds can play in a portfolio: as a diversifier to equities, hedge against equity downside movements, and to generate income. We view 2022’s backdrop as an unpleasant but rare occurrence as opposed to a fundamental change in what has historically served as a sound financial approach.  

Asset classes have changed, and so should the 60/40 portfolio  

When the idea of using a balanced portfolio was first introduced, asset classes were viewed in broad general terms. For the 60/40 concept, that meant large caps for the equity portion and primarily U.S. Treasurys for bonds. Of course, since then, a more nuanced view of asset classes has emerged. Stocks are broken into groupings by market cap, sector, industry and country of origin, among other characteristics. Likewise, fixed income can be dissected by credit quality, duration and whether an issue can be converted into stock, as well as a number of other criteria. Additionally, asset classes such as real estate and commodities are more readily available for investors. We believe the greater differentiation available within asset classes enhances the robustness of the 60/40 concept rather than undermines it. 

The 60/40 portfolio was initially conceived as a way to reduce risk through diversification. The additional differentiation available in both asset classes that weren’t easily accessible when the concept was first introduced simply makes an even greater level of diversification possible for investors. 

Consider the anomaly of 2022 with stocks and bonds producing negative returns in the face of elevated inflation. We believe the poor showing reinforces the importance of diversification. However, instead of being constrained to simply large cap equities and U.S. Treasurys, investors have access to additional asset classes, including commodities, which typically serve as a hedge against periods of high inflation and came out as a top performer last year. It’s worth noting that in four of the five times that stocks and bonds produced negative returns in the same year, commodities posted positive results. The sole exception was 1931, when the economy was in the midst of the Great Depression. 

We use nine distinct asset classes in total when constructing portfolios. This more differentiated approach allows us to make tactical “tilts” in response to short- and intermediate-term economic factors. Also, we can better allocate assets based on where we believe valuations are most favorable. For example, when valuations appear expensive in a given asset class (as they now appear in large cap stocks), we can tilt to cheaper parts of the market, such as small and mid-cap equities.  

A balanced portfolio may be better for most 

While the type of diversification achieved through a 60/40 portfolio may mean you will never nail the “big call” on the next bull run for equities or time the perfect trade to generate the greatest yield in fixed income, it helps provide a level of protection against making the “big mistake.” That translates into building portfolios that can generate upside in a host of market environments rather than concentrating capital into a single outcome. As a result, well-diversified portfolios will undoubtedly contain asset classes that underperform (and may underperform for quite some time).   

Despite the difficulties of 2022, our view is that diversification remains the best path forward to deal with life’s uncertainties. While we’ve heard talk that the challenges created by COVID spell doom for the time-tested 60/40 portfolio, we believe this view is misguided. Over the past four decades, we’ve experienced sustained periods of high and low inflation, peacetime and war, recessions and economic booms. Yet through all the ups and downs since 1976, a simple 60/40 portfolio of U.S. large cap stocks and U.S. investment-grade bonds has consistently posted positive returns when measured on a five-year basis. In fact, there have been only three months in which a 60/40 portfolio did not produce gains on a five-year basis—for the periods ending January, February and March of 2009 (during the Great Recession). That means in 99.4 percent of the months during the period, the 60/40 portfolio was up on a five-year basis. Importantly, we do not forecast that we are headed for another Great Recession and point out that even with the performance difficulties of the past year, according to our research, over the past five years through December 31, 2022, a 60/40 portfolio is up more than 6 percent. This is why the time horizon is critical when evaluating an investment strategy. Volatility experienced in any given year, in our view, offers little value when judging the soundness of an investment philosophy. Investment strategies should be built with the acknowledgment that the markets are dynamic and unpredictable. As such, portfolios should include investments that can shine against different backdrops or offset losses in other areas as needed over an extended period (usually five years or more). By this measure, the 60/40 concept had proven its value. 

Trust the whole portfolio, not its individual parts 

Don’t pull apart your portfolio judging the merits of each asset class individually. Instead, a Northwestern Mutual financial advisor can help you develop an investment plan that includes assets that work together to help you reach your financial goals in a variety of economic conditions. In addition, your advisor can build a plan that includes assets beyond investments that reinforce them. Working with an advisor and sticking to the plan you have built together—as opposed to chasing new “paradigms”—provides you with the tools to keep you on solid financial footing. You’re in this for the long term, and that commitment doesn’t change, no matter what the stock or bond markets do. 

Commentary is written to give you an overview of recent market and economic conditions, but it is only our opinion at a point in time and shouldn’t be used as a source to make investment decisions or to try to predict future market performance. 

Commentary is written to give you an overview of recent market and economic conditions, but it is only our opinion at a point in time and shouldn’t be used as a source to make investment decisions or to try to predict future market performance. 

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