60/40
The 60% equity, 40% bonds portfolio is a traditional asset allocation that’s used in many retirement accounts. The exact origin of the 60/40 portfolio is unknown. Maybe it started as 50/50 for a “balanced” approach but shifted to 60/40 when inflation sent bonds into a tailspin. Maybe it is just because equities outperform long-term, so advisors slowly shifted more weight to equity to help increase their client’s chances of meeting their retirement goals.
Regardless, it is what it is. The 60/40 portfolio has been the most popular set-it-and-forget-it approach to investing for quite some time. The main reason why this investment approach has stood the test of time is that it has been on a serious run for close to four decades. Here are the annual returns since the early 80’s for a 60% equity, 40% bond US portfolio rebalanced monthly.
That’s an incredible track record. Since 1982, the 60/40 has returned 10.9% in the US. More than 20% of calendar years had returns over 20%. Many advisors wonder why the average investor expects their portfolios to return more than 10% per year. It’s probably because a balanced portfolio has returned over 10% per year since the 1980’s!
Why has this been the case? Obviously this is a tough question and there are many factors that have contributed to the 60/40’s excellent performance, but the main reason is falling interest rates. We have been experiencing the greatest bond bull market we will ever see. Here’s what interest rates have done over 60 years.
Quick math: if the yield on your 10 year bullet bond with $100 face value shrinks from 15.8% to 0.7%, what was your capital gain on the bond?
Price of bond with 15.8% rates: 100/(1+15.8%)¹⁰ = $23.06
Price of bond with 0.7% rates: 100/(1+0.7%)¹⁰ = $93.26
That is more than a 300% return! Keep in mind that this return has been amortized over four decades, but it is still quite meaningful. This has been a major tailwind for 60/40 portfolios. This is also a tailwind that you cannot expect going forward. How far negative can interest rates go before society outright abolishes central banks? As a further example of just how insane the bull market has been for bonds, if you bought SPY (SPDR S&P 500 ETF) and TLT (iShares US Long Term Treasuries) in Oct 2007, your TLT position would be ahead!
Moreover, there is no better predictor for future bond returns than your current yield. You can clearly see that relationship if you map out what the interest rate was at a given time, and then what the returns were for those bonds over the next few years. This next chart shows exactly that. The blue line is 5 year US treasury yields. The yellow line is what a 5 year treasury bond index returned over the next 5 years from that given point. The yellow line stops in 2016 because we haven’t had 5 years of returns since then. You can clearly see the tight relationship between yields and returns. With interest rates at an all-time low, the outlook for high quality government bonds is pretty bleak.
Equities have had quite a tailwind as well as valuations have increased substantially. The S&P 500 has had its price-to-earnings ratio, or how much you have to spend to buy a dollar of earnings, go from about $7 in the early 80’s to $24 dollars today. This is about a 240% increase that has been amortized over 40 years into equity owners returns. While there are also many contributing factors to this huge run in valuations, one of the biggest reasons, again, is interest rates. Investors can’t earn enough return on bonds, so they have shifted their asset allocation to more growth-oriented investments like equities, which bids up the price of those equities. This isn’t theory, you can see this by looking at all equities divided by all financial assets not owned by central banks or financial institutions, which gives you a proxy for what the overall equity allocation is for investors. That allocation went from less than 10% in the early 80’s to over 30% today.
Going forward, you can estimate equity returns by decomposing them into different sources. Namely, equity returns come from one of the following: dividend yield, earnings growth, and change in valuation. Let’s call dividend yield 2% long-term to make it easy. Let’s also assume that valuations stay where they are over the long-term (aka they don’t mean revert to historical levels, but don’t grow from here either). That leaves earnings, which is a function of revenue growth and profit margins. Revenue growth is tied to long term nominal GDP, so let’s call that 5% (3% GDP growth and 2% inflation), which may be optimistic. Profit margins are usually mean reverting like valuations, and like valuations they are far above the historical average. That said, let’s just assume they stay above historical norms. That means a reasonable return that equity investors can expect is 7% long-term.
Total Equity Return = Dividend Yield + Change in Valuation + Change in Earnings
7% = 2% + 0% + 5%
Obviously there’s quite a few assumptions here, but that gives you a base case. You can certainly argue that valuations or profit margins will go one way or another, but valuations and profit margins can’t grow forever, just like interest rates can’t fall forever.
There is one more potential headwind for the 60/40 portfolio and that is correlations. Since 1980, correlations between equities and fixed income have been negative. This means that when your equities fell, your bonds were probably positive. This negative correlation is huge for a 60/40 portfolio as it improves risk-adjusted returns substantially. If you began investing in 2000 or later, you have only known negative correlations for equities and fixed income, but positive correlations used to be quite common. Here’s the 10 year rolling correlation for US stocks and bonds.
As you can see, it’s pretty naïve to think negative correlations between stocks and bonds is a normal thing. They have mostly been positive since the second half of the 20th century. This is in large part to inflation. Inflation spikes are very bad for bonds and not good for equities in the short-term. That means that when inflation spikes, there’s nothing protecting a 60/40 portfolio. We don’t know if inflation will return someday, but history tells us that counting on your bonds to protect you in all economic environments is unwise.
As you can see, there are many, many reasons why the 60/40 won’t be what it was going forward. Over the next 40 years, interest rates aren’t going to fall like they have over the previous 40 years. Considering a Canadian Government 10 year bond yield 0.7% at the time of writing, investors can’t afford to allocate 40% of their portfolio to them if they want to meet their goals. As for equities, stretched valuations and margins, along with meager economic growth will challenge returns from this point forward. Finally, there may be a day that the correlation between equity and fixed income turns positive again, which means investors in a 60/40 portfolio will have nowhere to hide. Understanding these facts is the first step in creating a portfolio that will meet your goals and expectations.
