2023 should be a brighter year for the traditional 60/40 portfolio

Published Wed, Dec 21 20223:23 PM ESTUpdated Thu, Dec 29 202210:31 AM EST

Investors who stuck to the traditional portfolio breakdown of 60% allocated to stocks and 40% allocated to bonds were hit hard this year as both asset classes shed value. The S & P 500 has slumped about 18.6% year to date and remains in a bear market. Technology stocks, which had been high flyers in previous years, plummeted — the tech-heavy Nasdaq Composite is down more than 32% in the same period. Bonds also lost value for investors this year, going against the traditional correlation where they act as a hedge to stock market volatility. The Bloomberg U.S. Aggregate, a bond benchmark, has slipped more than 12.2% year to date. The reason? A combination of economic uncertainty in the post-Covid world coupled with high inflation, which prompted the Federal Reserve to hike interest rates by the most in decades. That weighed on stocks and pushed up bond yields, which are inverse to price. It amounted to a "perfect storm," Ed Clissold, chief U.S. market strategist at Ned Davis Research, wrote in a Dec. 6 note. In addition, 60/40 portfolios saw their worst annual return since 1926, he said. Now, investors may be wondering what the new year brings. There's still a lot of economic uncertainty in the U.S. as the Federal Reserve continues to hike interest rates — albeit at a slower pace — to tame high inflation. Traders are bracing for a recession and some companies have already started to trim their ranks in preparation for leaner times ahead. Still, most analysts don't expect the year to yield a worse performance than 2022 for the standard 60/40 portfolio. That bodes well for investors who still have a traditional portfolio balance. "For folks who have weathered the storm, you can start to see the clouds clearing on the horizon," said Ross Mayfield, an investment strategy analyst at Baird. "We would say think long term and stick to your plan." What's to come Part of the reason that experts anticipate better returns in 2023 is that 2022 has been an unusual year for markets, between economic uncertainty, rising interest rates, global political unrest and more. "2022 was a pretty big anomaly in the sense that it was only the fifth time since the 1920s that both stocks and bonds were down in the same year," said Liz Young, head of investment strategy at SoFi. "So, the likelihood of that happening again is very slim." We need the Fed to win the inflation war to get back to more normal returns." Senior investment strategist, U.S. Bank Rob Haworth In addition, though the U.S. could be heading for a recession in the second half of the year, it doesn't mean that stocks are going to fall again — the stock market often leads the broader economic cycle by a half of a year or more. Part of the reason that stocks have slipped this year is the Federal Reserve's aggressive path of rate hikes to tame high inflation. At some point — and potentially as soon as next year — the central bank may have to pivot from its agenda. "Historically when the 60/40 has done really poorly, it has often been associated with an aggressive hiking cycle," said Mayfield. "In the years following, you usually get a reversal of the Fed rates, and fixed income has a really nice running performance, and then longer term, you get the stock performance as well." Of course, as the Fed continues to hike rates, even at a slower pace, it could lead to more volatility in the first half of 2023. That pain is worth the long-term payoff, however. "We need the Fed to win the inflation war to get back to more normal returns," said Rob Haworth, senior investment strategist, wealth management at U.S. Bank. Will negative stock and bond correlation return? Another reason that 60/40 portfolios were hit so hard in 2022 was that the correlation between equities and bonds flipped — instead of balancing each other, the asset classes both shed value at the same time. CNBC Pro's guide to investing in 2023 The Dow's yearly performance is beating the S & P 500 by the most in decades. Here's why Here's why 2023 could be another solid year for dividend stocks — and how to play it Top Wall Street strategists see a bumpy 2023 ahead with minimal returns for stocks The crypto investing outlook for 2023 after a 60% decline in bitcoin this year "Many investors now wonder if the once-normal negative correlation between equities and bonds will ever return," Galina Pozdnyakova of Deutsche Bank wrote in a December note. "That adds to concerns over several other market correlations that have not worked out as many investors expected, such as gold and inflation." Generally, it is expected that the negative correlation between stocks and bonds will return over time — in the last part of 2022, the asset classes again started moving in opposite directions more frequently. But investors often miss an important point in this debate, according to Pozdnyakova. That is that the overall split of the portfolio between stocks and bonds may matter less than the risk exposure of assets and how volatile they're likely to be in an uncertain market. "The market drops this year mainly highlight the fact that while the market weights of equities and bonds are split as 60/40, the risk exposure within the portfolio is much more highly weighted towards equities – often close to 90 percent," she said. That means that what stocks you have in your equity portfolio and how risky they are is more important than the balance between risk assets and fixed income – though most financial planners would recommend you have both. What investors should do now Investors may still want to review their portfolios and rebalance for the year ahead. It may be a good idea to check allocations to different sectors to ensure you're set up for success next year and beyond. "I really don't think tech is going to be the star of the show, at least for the first half of 2023," said Young. "If you're accustomed to having a big overweight to technology or being even market weight technology, I would maybe consider going a little underweight and spreading it across some more value-oriented sectors." After the yearly performance, some of your allocations might be out of balance, or you may want to increase the diversity of the stocks you invest in to shield yourself going forward. "Diversification benefits you when you have a common factor that is so painful for markets," such as high inflation, said Haworth. That also applies to asset classes, meaning that investors should look at their balance of stocks to bonds as well. Going into a recession, the fixed income space may be a safer place to hold money than stocks. Of course, no investor has a crystal ball to determine what exactly will happen in markets in 2023. Financial experts recommend that people invest with a long-term time horizon so that in the end, one year's performance isn't as important. And even though the traditional 60/40 portfolio had a dismal 2022, investors shouldn't write it off. They also shouldn't discount it if the beginning of 2023 is volatile, as it's likely to be before the market finds its footing. "We wouldn't throw that out in the long term, but in the near term it's been a challenge," said Haworth.