The classic 60/40 rule — an investor should put 60 percent of their portfolio in stocks and 40 percent in bonds — is popular for a reason: It has a good historical track record of delivering equity-like returns, while lessening the risk of serious annual portfolio drawdowns.
S&P 500 and 10-Year Treasurys has delivered an average annual total return of 9 percent, or 78 percent of the total return for just the S&P 500 (11.5 percent). After inflation (using annual CPI) this translates to a 5.9 percent average total return for 60/40, or 70 percent of the average real returns for the S&P 500 (8.4 percent).
The 60/40 portfolio saw 19 years with negative total returns during the period from 1928 to 2017 (21 percent of the time). The worst drawdowns for the 60/40 portfolio since World War II: 1974 (-14.7 percent) and 2008 (-13.9 percent). The returns on just the S&P 500 in those years were more than twice the losses of the 60/40 portfolio: -25.9 percent and -36.6 percent, respectively.
The key to the benefits of the 60/40 rule is negative correlation between stocks and bonds. Stock and bond returns show no historical return correlations (0.03) over the 1928–2017 time frame. A correlation of 1.0 implies perfect correlation.
The wrinkle: Stock and bond correlations are not static across time. Over the last 20 years (ending in 2017), the correlation between the two has been -0.66 based on total annual returns, an exceptionally negative correlation. For 2008 to 2017, specifically, it produced a -0.78 correlation.
Worth noting: The prior peak for 10-year stock-bond correlations was back in 1964, at -0.64.
Stocks and bonds can — and have — shown positive return correlations throughout history, lessening the ability of a 60/40 portfolio to provide the benefit of diversification. Given that we are ending a period of exceptionally negative stock-bond correlations and face the very real possibility of an extended period of rising inflation, what should a 60/40 portfolio owner consider?
A few thoughts:
The five years after the prior trough for stock/bond correlations (back in 1964, at -0.64) saw 10-year Treasurys deliver just a 0.06 percent compounded average total return between 1965 and 1969. Moreover, CPI inflation went from 1 percent in 1964 to 6.2 percent in 1969, so bond investors saw negative real returns over this period.
Equity returns over the 1965–69 period were choppy and substandard. The compounded annual total return for the S&P 500 over the period was just 5.0 percent. By comparison, the 60/40 portfolio showed a compounded annual return of 3.2 percent from 1965–69. This lagged inflation, which showed compounded growth of 3.9 percent over the same period.
While we doubt U.S. inflation will rise as quickly as in the late 1960s, the 1965–69 period shows the pitfalls of the 60/40 portfolio. Equities may not excel when inflation rises, but they certainly do better than bonds.
Long periods of rising inflation recouple stock and bond correlations, and this continues over the crest for the peak of higher prices and into the next down cycle. Ten-year price-return correlations peaked in 1994-95, at 0.74, reflecting a long journey through high inflation (early 1980s) through monetary discipline (mid- to late-1980s) and eventually lower long-term inflation expectations (1990s).
We think this analysis has two takeaways.
First, 60/40 seems too heavily weighted to bonds for this point in the correlation cycle. Whether the optimal mix is 80/20 or 65/35 is a matter of risk preference. We tend toward the latter out of conservatism but understand it leaves little room for positive real returns if inflation accelerates.
Second, any blend of bonds and stocks will have lower future returns and higher volatility than the recent past. Stock valuations are historically high, and bond yields are still near all-time lows. Neither is the recipe for outsized future returns. That makes getting the weighting to each asset class right all the more important.
— By Nicholas Colas, co-founder of DataTrek Research