The 60% equity/40% fixed income portfolio, rooted in the Nobel Prize–winning work of Harry Markowitz and William Sharpe on Modern Portfolio Theory, has fallen out of favor in recent years. And there are a number of reasons for this.
The Federal Reserve’s interest rate policies since the Great Financial Crisis have certainly had an impact. The outperformance of a handful of large-cap growth stocks that led to concentration of the major stock market indexes has also factored in. And finally, the disappointing performance of bonds in 2022 — a year in which equity markets also declined — seemed to be the icing on the cake.
But are investors giving up at just the wrong moment? That potential seems to be real when you survey today’s global equity and fixed income market landscape.
Yields on fixed income investments are at levels that can generate attractive amounts of income within a portfolio. Meanwhile, the top 10 names in the S&P 500 account for more than 40% of the index, an all-time high by a significant margin.
Investors have come to believe that these few names are the ones that matter most when it comes to portfolio construction. If you have exposure to those names, they assume, nothing else matters for long-term success.
All About U.S. Stocks?
Interestingly, the Magnificent Seven can be narrowed down to one stock in terms of the effects on the S&P 500 Index. Nvidia has been a strong investment over the past several years.
If you take Nvidia out of the S&P 500, the remaining 499 stocks underperformed over the past three years since the inflation-driven global market low — meaning that, during this period, equities in both Europe and Japan have actually delivered stronger returns.
Perhaps European aerospace and defense isn’t a big surprise among emerging global themes, given all the news coverage on increased spending from Germany and other NATO countries. But international developed market banks? That’s a stealth rally for sure.
And that’s one advantage of a 60–40 allocation: It doesn’t require a set-it-and-forget-it strategy. As investors face significant uncertainty about fiscal policies, global trade partnerships, monetary policy, economic growth, corporate earnings and valuations of large-cap stocks, we believe that actively managing a diversified portfolio is the best way to proceed.
Timing Markets Is Notoriously Difficult
While large-cap growth stocks have gotten most of the attention, on some level it represents recency bias.
Without a doubt, large cap has been the best-performing asset class over the past 15 years. But it was the best asset class on an individual basis in only three of those years. The real estate investment trust asset class was the top performer in six of those years, and small caps held that spot in three other years.
While past performance is certainly no guarantee of future results, maintaining the flexibility to adjust to whatever the environment turns out to be — within a defined equity allocation — could provide advantages moving forward.
Bond Scars From 2022 Linger
Investors have long appreciated that stocks and bonds complement each other, with bonds consistently acting as downside protection in years of down equity markets. Between 1980 and 2021, the S&P 500 declined in seven of those years. The Aggregate Bond Index, on the other hand, rose in all seven of those years.
And then came 2022.
Bonds declined 13% in a year when the equity market also came under significant pressure. The investor sentiment was surprise and disappointment, and many may have questioned the value of bonds and the role that they played in their portfolio. Yet bonds have had negative returns in just four of the past 50 years; the S&P 500, meanwhile, has declined in nine of those years.
One issue that fixed income investors faced in 2022 was that rates were low coming into the year, and expectations were that if they moved higher, it would happen gradually. But the Fed raised rates aggressively, investor expectations proved to be wrong and markets reacted accordingly.
Currently, global rates are higher than they were entering 2022. This should align expectations with the likely path of interest rates going forward as inflation proves to be sticky in the intermediate time frame. It also gives investors a chance to lock in attractive yields to provide income for their portfolios.
Back to the Future
The ultimate determination for the appropriate equity to fixed income allocation is client specific. Factors such as age, risk tolerance, when the money is needed and its intended use — like buying a house, paying for college or funding retirement — should all be considered.
The 60–40 allocation isn’t appropriate for everyone. But investors in the middle of the risk and time spectrum shouldn’t fear they are missing out on something better.
Sixty percent of the portfolio invested in equities can help provide an investor upside and growth over time, while the 40% allocated to fixed income can help provide a needed buffer if equity markets go through a period of decline, which we have seen repeatedly in this century.
And, at the same time, it can help provide a steady income stream to enhance returns.
Historically, a 60–40 portfolio has served investors well over the long term when compared to stock and bond returns over the same period. While that hasn’t been true over the past few years, recent underperformance is not a reason to dismiss the strategy entirely; it simply reflects an unusual period in markets.
Clients’ goals remain long-term, and for many, a mix of roughly 60% equities and 40% fixed income continues to align with these goals. Given the uncertainty about the most likely path forward for the economy and markets, now seems like a good time to revisit this classic approach for clients — especially as equity opportunities broaden and bond yields are in line with historic norms.
Chris Fasciano is chief market strategist at Commonwealth Financial Network, an RIA/independent broker-dealer providing resources and consulting services to support thousands of advisors and financial planners.
© Touchpoint Markets, All Rights Reserved. Request academic re-use from www.copyright.com. All other uses, submit a request to TMSalesOperations@arc-network.com. For more information visit Asset & Logo Licensing.