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The 60/40 portfolio has long been a staple for investors with a moderate attitude to risk.
The idea behind the allocation is that investors can avoid suffering large falls thanks to the inverse relationship between equities and bonds. Yet this theory fell flat in 2022.
Last year, the 60/40 portfolio suffered it’s worst performance in 23 years!
So what was the reason behind this ‘annus horribilis’ for the 60/40 portfolio? And what are the chances of it making a comeback? Let’s explore these questions and more….
The 60/40 asset allocation is where investors put 60% of their wealth into equities and 40% into bonds.
The main purpose of buying a mix of equities and bonds is to help with portfolio diversification.
Diversifying your portfolio is an important part of investing. It helps to reduce the risk of large falls. That’s because if one particular type of investment has a bad year there’s a fair chance the performance of other assets you hold will help cushion the blow.
Bury your head into any ‘investing for newbies’ textbook and it’s likely you’ll see the 60/40 allocation described as a relatively risk-averse way to invest.
Not only are equities and bonds different types of investments in their own right but they also have an inverse relationship. So when equities fall, bonds typically rise (and vice versa). So for investors worried about stock market volatility, a 60/40 portfolio is often the suggested go-to.
In fact, 60/40 is a popular allocation for a number of pension funds for this very reason.
According to Blackrock, a typical 60/40 portfolio suffered a 17% hit last year.
To put that into perspective, in the 23 year period between 1999 and 2022, 60/40 investors have enjoyed an average return of 7%.
However, last year was rather unusual as it was bad year for both equities AND bonds.
We’ve mentioned above how equities and bonds traditionally have an inverse relationship with one another. For example, during times of economic turbulence the stock market usually suffers a slump. However, during such times bond prices often hold their value – or even rise – as nervous investors become more interested in ‘safe’ assets.
Last year, however, despite a sluggish performance for the UK economy, bond prices proved to be anything but safe. Similar to stocks, bond prices took an almighty hit in 2022 and this was down to the unfortunate cocktail of high inflation coupled with rising interest rates.
Let’s explore the impact of these two factors in more detail…
Last year the UK witnessed its highest rate of inflation for 40 years, hitting double digits in September. These are the ONS’s inflation calculations remember and it’s worth understanding that many believe the official figures are too conservative.
High inflation is bad news for businesses and the stock market. For example, when business face higher costs, such as for raw materials, then this can have a massive impact on their profits – especially if they’re unable to pass on the higher costs to consumers in the form of higher prices.
Put simply, consumers aren’t always willing, or financially able to pay higher costs, which can lead to a cut in their levels of consumption.
Also, high inflation typically leads to demands from workers for higher wages in order to keep up with the rising cost of living. Again, this is another factor that can hamper growth for businesses.
Due to rampant inflation, the Bank of England hiked interest rates on several occasions last year in order to increase the cost of borrowing.
During the course of last year the base rate climbed from 0.25% to 3.5%.
While rising interest rates can be an effective weapon against inflation, it can turn out painful for bond holders. One of the reasons for this is that when interest rates rise, it becomes a lot easier to earn a decent, risk-free return from cash stashed in a traditional savings account. ,
This is why bond prices often suffer when interest rates rise as bond yields must soar in order to attract new buyers.
When it comes to investing predicting the future is often a futile pursuit. However, there are individuals, and major investing players who believe there’s still mileage in the 60/40 portfolio.
For example, according to Goldman Sachs Asset Management, history tells us that the 60/40 portfolio tends to bounce back after a period of negative returns.
The company points to bond falls in 2018, 2008 and 2002. After each of these challenging years, bonds enjoyed a resurgence. In 2019, 2009, and 2003 bond prices rose between 18% and 22%.
It also shouldn’t be forgotten that while rising bond yields is bad news for existing bond holders, in the long-term, higher yields can lead to more generous returns. So, investors who buy bonds now and sit tight are in line to be rewarded in future.
That said, there are no guarantees of course. Some investors have concluded that time is indeed up for the ‘tried and tested’ 60/40 portfolio. It has been suggested that buying only bonds and equities simply doesn’t deliver enough diversification in the current economic environment.
If you want to allocate your assets in a 60/40 manner then buying an exchange-traded fund (ETF) is probably the easiest way to go about it. Vanguard’s LifeStrategy 60% Equity Fund is a popular 60/40 ETF.
ETF’s can be a cheap way to invest and they have the capability to automatically re-balance your portfolio. So should equities rise and bonds fall, thanks to automatic re-balancing, you wouldn’t be left with a greater proportion of your assets sitting in equities. This is important, as if you didn’t re-balance your assets, it’s likely your portfolio would lose its 60/40 allocation over time.
If buying an ETF isn’t for you, then there’s also the option of buying individual shares or bonds through a traditional investing platform. If this sounds like your cup of tea then take a look at our article that explains how to buy shares.
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Disclaimer: MoneyMagpie is not a licensed financial advisor and therefore information found here including opinions, commentary, suggestions or strategies are for informational, entertainment or educational purposes only. This should not be considered as financial advice. Anyone thinking of investing should conduct their own due diligence.