Rethinking 60/40 Portfolios With More Bonds

When modern asset allocation first became an idea back in the 1950s, the concept of the 60/40 split was first born. Analysts postulated that this was the optimal breakdown of a portfolio to generate great long-term returns with minimal risk. Simply, investors would have 60% of their portfolios in stocks and another 40% in high-quality investment-grade bonds. The idea is that the returns from the bond side would smooth out the volatility from the stock side. The combination would provide a smoother and better ride for investors. Vanguard founder Jack Bogle ran with the idea and made it popular with investors.

And it turns out that Jack and those early analysts were right.

Since the 1980s, a 60/40 portfolio would not only have smoothed out volatility, but it would have provided a better long-term return for portfolios. Over the last 40 years, the spilt would have provided an average annual return of 7.5%. This is versus a 7.2% return for stocks and a 6.2% return for U.S. investment-grade bonds.

However, lately, 60/40 has been a terrible bet for investors. With interest rates low and stocks surging since the Great Recession, the bond side has significantly dragged down returns for the asset allocation model. Then the bottom dropped out last year.

With the rise of inflation and the Fed’s recent moves to raise rates back to normal levels, bonds haven’t lived up to their low-volatility name. In fact, staid bonds plunged last year as the Fed raised rates, as did stocks. To that end, the classic 60/40 lost about 15% last year, the worst return since the Great Recession and the worst in real terms since the Great Depression.

The question for investors is whether or not 2022’s returns were the last nail in the coffin for 60/40. According to some big investment banks and analysts the answer is no, with some interesting caveats. According to Goldman Sachs, investors should stick with the strategy as the returns from the asset allocation model over the long haul have proven themselves. Others are rethinking that approach given the current outlook for bonds and stocks.

And that includes Vanguard and BlackRock.

Thanks to rising rates and the return to normalcy, the stock/bond return quotient is about to be flipped on its head. According to Vanguard, stocks should rise by just 4.7% to 6.7% annually over the next 10 years. That’s about half of stocks’ returns since the Great Recession.

The flip side is that thanks to rising interest rates and falling bond prices, bonds are now paying rates not seen in decades. The benchmark Bloomberg Aggregate Bond Index—which tracks investment-grade Treasuries and corporate bonds—is now yielding close to 5%. Pockets of bonds such as investment corporate and mortgage-backed securities are yielding more. Meanwhile, the risks of recession has many analysts predicting that the Fed will take its foot off the gas on rates, boosting bond prices.

With this in tow, 60/40 should become 40/60. Investors should be buying bonds over stocks and getting more of their return from yield than capital gains on the equity side.

According to BlackRock and J.P. Morgan, this will result in better long-term returns with lower risk over the next couple of years. Basically, resetting the allocation back to what 60/40 was originally designed to do: provide smoother, long-term returns.

Given the current yields on bonds and the poor outlook for equities, flipping the classic allocation model to have more bonds than stocks could have some real appeal for investors, particularly those near or in retirement. Getting a real return from yield has plenty of merit. Luckily, getting that new balance is quite easy.

With one ticker, investors can boost their exposure to investment-grade bonds via the iShares Core US Aggregate Bond ETF (AGG) or Vanguard Total Bond Market Index Fund ETF (BND). Here, investors can have access to a wide swath of IOUs for a low cost. Some of the biggest gains could be had in short-term securities as the Fed isn’t done raising rates yet. Just a few months ago, T-bills were paying next to nothing. Now, they are paying over 4%. The SPDR Bloomberg 1-3 Month T-Bill ETF (BIL) makes adding them a breeze.

An even easier way? Put your portfolio in the hands of a professional. The Vanguard Wellesley Income Fund (VWINX) is already a balanced fund set at a 40% stock, 60% bond allocation. Overall, Wellesley should perform very well as the new paradigm comes to fruition.

All in all, the classic 60/40 portfolio may not be dead, but it does need some tweaking for the years ahead. With bonds now driving the show, investors may want to switch their allocations and make a flip. Fixed income investors should be pleased with this fact.

Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.