The 60/40 allocation strategy is frequently recommended when beginning your investing journey. With 60% of your portfolio in equities and 40% in bonds or other fixed-income investments, this approach has traditionally provided a balanced benefit, with high growth potential from stocks and a safety net from bonds.[1] Stocks and bonds are usually negatively correlated, which means that when one goes up the other typically goes down. Having both in a portfolio adds balance since the two rarely dip at the same time. However, 2022 broke the mold. Both stocks and bonds dipped by large amounts and that has brought the wisdom behind the 60/40 portfolio back into question.
- Stock Markets Take a Dip
Historically, stocks have fared well in environments with low inflation and low-interest rates. However, 2022 recorded the highest inflation levels in 40 years. This motivated the Federal Reserve to raise rates six times in a single year and begin efforts to restrict the supply of money flowing through the economy.[2] Stock prices dropped substantially this year due in no small part to high inflation, rising interest rates, weaker consumer demand, crumbling corporate earnings, and a healthy dose of general economic uncertainty.[3] Because stocks account for more than half of a 60/40 portfolio, their drop has an outsized impact on portfolio performance.
- Bond Markets Drop Too!
Generally, bonds tend to hold up ok in times of economic uncertainty. Investors pull their money from volatile stocks and reposition it with investments into stable, boring bonds. It’s what’s known as a “risk-off” stance. This increased demand for bonds pushes up their prices and drive values higher (and yields lower). It’s part of what makes the balancing act in a 60/40 portfolio work so well. But that that didn’t happen in 2022.
Instead, bonds sold off in tandem with stocks. Bond prices and interest rates are also negatively correlated, so bond prices dipped throughout 2022 as the Fed hiked interest rates. And there weren’t enough bond buyers rushing in to drive up prices to a level that would offset the price declines caused by the interest rate increases. With just a few trading days left in the year, it will take nothing short of a miracle for this not to be the worst year for bonds in living memory. Here’s the last 45 years of bond returns as a guide:
This was unusual. Even in previous periods with record high inflation and interest rates north of 15%, bonds still had positive returns! What happened?
Zero to One
Bonds have two components of their return; the interest they pay and the underlying price appreciation/depreciation of the asset. What supported bond returns in previous rate hiking cycles was the high level of interest that they paid. Prices dropped when rates rose in previous years just as in this year, but the interest payments they made were enough to offset the declines! Not so in 2022.
Interest rates hit some of their lowest levels in US history in 2021. Money was almost free and bonds paid next to nothing. So there was almost no yield available to offset the price declines in bonds when the Fed started raising interest rates in 2022. It would be entirely up to bond buyers to offset those price declines through increased demand, and there just weren’t enough of them out there to do it.
As it turns out, taking interest rates from almost zero to one percent is far more devastating than going from, say, 10 to 11.
The safety net of the 60/40 portfolio failed in 2022. But that doesn’t mean it’s worth abandoning entirely. Markets won’t face the same headwinds in 2023 that they did in 2022, for example, and the destructive fundamental forces tearing apart this allocation are expected to lessen in the coming year. We believe there will always be a place for this allocation in retirement planning, but whether its right for you personally is another issue. You may not feel confident in this strategy or in putting your hard-earned money at risk. To find out what investment strategy works best for you and your objectives, talk to us today and get a review of your finances.
[2] https://www.bankrate.com/banking/federal-reserve/how-much-will-fed-raise-rates-in-2022/
[3] https://www.cnbc.com/2022/10/03/why-60/40-portfolio-is-on-track-for-its-worst-year-ever-says-cio.html
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