The 60/40 portfolio

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Equities have performed best. A buy-and-hold strategy has worked perfectly for investors who haven’t needed to draw on their portfolios. In times of market stress, bonds have dampened portfolio volatility. Having 40% of the portfolio in bonds helped investors during the dot.com bust and the global financial crisis.²

However, most investors need to draw cash from their portfolios at some point, which means that volatility or standard deviation becomes relevant – particularly over shorter time periods. The standard deviation of a portfolio comprised solely of equities was significantly higher than the standard deviation of a 60/40 portfolio, but only improved the annualised return by 0.8%.³ In other words, the 60/40 portfolio has achieved better risk-adjusted returns.

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Several disinflationary forces have prevailed over the past half-century. Ageing demographics, the growth of IT, the re-emergence of China and globalisation amongst others. These forces have kept a lid on inflation and allowed central banks to operate without worrying too much about rising consumer prices. As a result, interest rates have been steadily falling. As rates and yields have fallen, bond prices have risen, and so has the price of equities. Both bond and equity markets have had a 40-year tailwind of falling interest rates. Interest rates can’t fall much further from here – so what does the future hold for bonds?

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Bonds have historically acted as an offset to equities in market crises.

But this chart demonstrates that bonds are very unlikely to do this job in the future. The blue bars illustrate how far yields must fall to offset a 10% decline in equity markets for a 60/40 portfolio.

With bond yields already so low, there is no scope for the multi-decade bull market in bonds to continue indefinitely. From this point there appears to be an asymmetric risk; bonds provide poor (in some cases negative) yields and limited downside protection.

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Both bonds and equities trade at valuations close to all-time highs. Yes, if rates are low, then using a discounted cash flow to value stocks (estimating the present value of future earnings) goes some way to justifying record-high valuations. Yet by whichever metric you choose to use, equity valuations appear stretched.

But valuations don’t tell the whole picture. Seven stocks now account for over 25% of the value of the S&P 500.⁴ This narrow market leadership represents a very crowded momentum trade, a trade that hides a worrying fragility.

Momentum can reverse quickly, such as in November 2020, when news of an effective vaccine caused 10-15% to be wiped off the value of several major tech stocks – the lockdown winners – in one day.⁵ Bonds did little to protect portfolios on that day.

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Nominal returns in the 1970s were reasonable, but when you factor in the high inflation, the picture changes. You lost 60% of the real value of a 60/40 portfolio between 1970 and 1975.⁶

Most investors alive today have never encountered significant inflation. Quantitative easing boosted asset prices but had no impact on consumer prices. Investors do not believe that inflation is coming. However, the deflationary forces of the past five decades are waning and the response to the pandemic has seen a monumental rise in government spending. Most central banks have used rhetoric suggesting they are willing to let inflation overshoot their targets. The inflationary chips are stacking up.

Inflation is a menace worth protecting against. It is a major risk to the conventional 60/40 portfolio. Equities suffer, as the experience of the 1970s shows, but their earnings will eventually grow as prices rise. Inflation is a much bigger risk to bonds – they will not protect the real value of portfolios. Alternative assets are required.

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The key to survival will lie in diversifying beyond the traditional balanced portfolio.

In a market regime change, in which equities and bonds fall together, investors will need an asset with low correlation to these markets, and negative correlation at points of stress. Traditional alternatives are often pseudo equities, so a genuine diversifier is required within portfolios. Ruffer is one such example, providing positive returns through the dot.com bust, the credit crisis and most recently in the covid-19 shock.

This chart shows how the introduction of Ruffer to a balanced portfolio has improved risk-adjusted returns over the last 25 years. Ruffer’s all-weather approach means that we are not tied to benchmarks. This allows us to challenge market certainties. The result is a genuinely different return profile. One which can enhance the traditional balanced portfolio, decrease volatility and improve returns over the long-term.