A 60:40 stock/bond portfolio should post a solid 6% annual return over the next 10 years, Morgan Stanley predicts

Published Mon, Jul 25 202211:22 AM EDTUpdated Mon, Jul 25 202212:24 PM EDT

There's still merit to the classic investment portfolio composed of 60% stocks and 40% bonds, according to Morgan Stanley. That balance has been called into question this year after both stocks and bonds suffered their worst first-half performances in decades, leading to large losses for traditional portfolios. But, the projected performance of portfolios with a 60:40 stock/bond split over the next decade is still more than 6% annually, and the diversification continues to offer investors some protection from choppy stocks, the firm argues. "Lower prices have raised our long-term return estimates for U.S. and European equities, while higher yields have boosted our estimates for U.S. and European bonds," analyst Andrew Sheets wrote in a note on Sunday. "For a 60:40 portfolio of U.S. equities and Aggregate bonds, for example, we forecast a 10-year return of 6.26% per annum, or 3.9 percentage points above expected inflation." This year's performance has been especially dire and called into question the ability of fixed income to offset volatile stocks for many investors. The drawdown of 60:40 portfolios this year wasn't necessarily as bad as similar events in 2002 or 2008, according to Sheets, but the fact that almost every asset class lost money has been concerning. What's usually happened, historically, is that when stocks lost ground, bonds gained. That negative correlation became positive during the pandemic, largely due to central bank moves to stimulate the economy from the Covid-related recession. "Whereas those previous large drawdowns left investors wishing they had held more fixed income, this year has left investors wishing they didn't own anything," he wrote. But bonds are still good diversifiers, even if they aren't as favorable as they were before 2020, Sheets argues. "Even if stocks and bonds are now positively correlated, that correlation is well below 1," Sheets said. "There are still plenty of days where they don't move together. That matters, as even 'positive' correlation can still have a dampening effect on volatility." Given the average volatility of the past decade, increasing the stock to bond correlation in a typical 60:40 portfolio would only increase its volatility to 10.8% from 10.2%, according to the note. "That's hardly cataclysmic," said Sheets. He also argues that while bonds are currently riskier than they've been at any other point for investors, they still aren't as risky as stocks. That means they can still be a good hedge against swings in the stock markets, smoothing the course for investors.