March 16, 2022 – The “classic” 60/40 portfolio, a strategy in which an investor holds 60% of their portfolio in stocks and 40% in bonds, has been viewed as a diversified and balanced allocation for decades.
Its success is not surprising.
Prior to this year, the 60/40 had generated more than 9% annualized returns over the long term, with reasonable volatility.
Given its solid long-term performance, many falsely assumed that the 60/40 portfolio would provide the same potential return profile on a go-forward basis.
Investors have been falsely comforted into unreasonable future performance expectations of the 60/40 portfolio.
The main culprit?
A 40-year bull market in bonds in which interest rates steadily declined, buoying the performance of the 60/40 portfolio.
Source: Board of Governors of the Federal Reserve System (US)
In the early 1980’s, the 10-year Treasury bond yield was more than 15%. It fell as low as 0.5% in 2020. As yields fall, bond prices rise.
A yield of 0.5% does not leave much room for yields to decline, especially if inflation were to rear its ugly head.
Fast-forward to 2022, and inflation is roaring.
Source: New York Times
Fiat currency is losing its purchasing power at the fastest rate in forty years.
Investors have reacted to surging inflation by selling bonds and demanding higher yields.
Source: Board of Governors of the Federal Reserve System (US)
10-year bond yields have jumped to 2.15% from 1.5% at the start of the year, leading to significant losses for bondholders.
With the latest inflation print of 7.9%, it is not out of the question to see 3% yields on the 10-year Treasury as a plausible scenario.
Long-term Government bonds have taken a substantial hit year-to-date.
Source: Google Finance
In a rising rate environment, supposedly safe bonds have become highly risky. For example, if yields were to keep rising to 3%, the 10-year Treasury would lose another -7%.
This spike in inflation and rate surge has coincided with geopolitical turmoil, resulting in declining risk assets, including stocks. The S&P 500 is down over -12% year-to-date.
In the current market environment, both stocks and bonds are dropping. Given how low current yields are, combined with the long-term forecasted rise in yields due to persistent inflation, bonds have ceased their function as an effective hedge to stocks.
The 60/40 portfolio has failed investors this year.
Source: Bloomberg
The 60/40 portfolio is down -10.3% year-to-date, a poor showing for the so-called “balanced” allocation.
As rates rise, it becomes increasingly clear that a two-asset portfolio (only stocks and bonds) is insufficiently diversified. Would you put all of your eggs in just two baskets?
A 60/40 portfolio has performed worse than expected in 2022 because stocks and bonds have been moving in lockstep – they have both traded down markedly.
A double-digit year-to-date decline indicates that not only is a two-asset portfolio not balanced, but it is downright risky.
Bonds are now positively correlated with stocks, meaning they have lost most of their diversification benefit.
What investors need is more diversification beyond just stocks and bonds.
Specifically, the key trait of a portfolio diversified is an asset that is either uncorrelated (moves independently) or negatively correlated (moves the opposite) to stocks.
One of these diversifying assets can be long-short equity.
Source: Bloomberg, Accelerate
Year-to-date, long-short equity has gained 7.3% while the S&P 500 has fallen -12.2% and long-term Treasurys have dropped -11.1%.
Diversification is the best tool to improve investor outcomes, by potentially lowering volatility (and smoothing out one’s investing journey) while increasing portfolio performance.
By including alternative investments such as long-short equity, allocators can improve risk-adjusted returns by capitalizing on the benefits of diversification.
And it’s never too late to diversify.
Happy investing,
-Julian
Disclaimer: This distribution does not constitute investment, legal or tax advice. Data provided in this distribution should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this distribution is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate Financial Technologies Inc. (“Accelerate”) as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Past performance is not indicative of future results. Visit www.AccelerateShares.com for more information.
