Why the 60/40 portfolio isn’t dead
Today’s topics
- Portfolio theory
Portfolio theory
Firstly, you’ve probably read a lot about how bonds are yielding very little, and hence “why bother with the 60/40 portfolio given those low expected returns”.
Well, let’s see how the mix of stocks, bonds, and the humble 60/40 allocation to both (here, 60% towards the S&P 500, and 40% to the US 7-10yr Treasury bond ETF) has performed.
It’s done great. How does it do that? Solid returns, better than bonds, with a notably smoother ride than that of an equities only portfolio.
The graph below tell us that different asset classes behave differently, and a little bit of maths and portfolio theory tells us that by combining imperfectly correlated asset classes, we can produce efficient portfolios.
Which is exactly what happens. Below are the annualised risk, annualised reward metrics for all 3 portfolios, and we note that the slight reduction in return is more than compensated for by the reduction in risk, for the 60/40 portfolio, such that the all important Sharpe ratio is much higher than for either stocks or bonds alone.
We can make the example even more extreme, for illustrative purposes. Pretend that bonds came with the well advertised low yields of the present day, but also had similar levels of volatility to equities. Would that, in this stylised example, ruin the investment case for adding bonds to the all-stock portfolio?
No – it depends crucially on the correlation between them. If we assume a (historical average) correlation of -.40 between stocks and bonds, we will still find that adding stocks to bonds moves the resultant portfolio up and to the left of the risk-reward graph below (or, if you prefer, adding bonds to stocks moves the resultant portfolio down and to the left).
So, to make the case that the 60/40 portfolio is dead, you need a well articulated reason for why stocks and bonds will have a different correlation over the forward looking life of the portfolio. And that’s a different conversation, and usually not at all the one being presented, which focuses in on the starting yield.
Important Information: This document has been prepared by Aequitas Investment Partners ABN 92 644 165 266 (“Aequitas”, “our”, “we”), a Corporate Authorised Representative (no. 1284389) of C2 Financial Services, (Australian Financial Services Licensee no. 502171), and is for distribution within Australia to wholesale clients and financial advisers only.
This document is based on information available at the time of publishing, information which we believe is correct and any opinions, conclusions or forecasts are reasonably held or made as at the time of its compilation, but no warranty is made as to its accuracy, reliability or completeness. To the extent permitted by law, neither Aequitas nor any of its affiliates accept liability to any person for loss or damage arising from the use of the information herein.
Please note that past performance is not a reliable indicator of future performance.
General Advice Warning: This document has been prepared without taking into account your objectives, financial situation or needs, and therefore you should consider its appropriateness, having regard to your objectives, financial situation and needs. Before making any decision about whether to acquire a financial product, you should obtain and read the relevant Product Disclosure Statement (PDS) or Investor Directed Portfolio Service Guide (IDPS Guide) and consider talking to a financial adviser.
Taxation warning: Any taxation considerations are general and based on present taxation laws and may be subject to change. Aequitas is not a registered tax (financial) adviser under the Tax Agent Services Act 2009 and investors should seek tax advice from a registered tax agent or a registered tax (financial) adviser if they intend to rely on this information to satisfy the liabilities or obligations or claim entitlements that arise, or could arise, under a taxation law.