The S&P 500 just had its worst first half in more than 50 years, which 'stressed' this classic investment strategy
- The S&P 500 Index of stocks had its worst first half since 1970, losing almost 21% in the first six months of the year.
- Meanwhile, the Bloomberg U.S. Aggregate bond index is down more than 10%, a rare dynamic given bonds' typical role as a portfolio ballast when stocks plunge.
- Investors may be rethinking their 60/40 asset allocation strategy. It remains sound but may need a slight adjustment, financial advisors said.
The S&P 500 Index, a barometer of U.S. stocks, just had its worst first half of the year going back over 50 years.
The index fell 20.6% in the past six months, from its high-water mark in early January — the steepest plunge of its kind dating to 1970, as investors worried about decades-high inflation.
Meanwhile, bonds have suffered, too. The Bloomberg U.S. Aggregate bond index is down more than 10% year to date.
The dynamic may have investors re-thinking their asset allocation strategy.
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While the 60/40 portfolio — a classic asset allocation strategy — may be under fire, financial advisors and experts don't think investors should sound the death knell for it. But it does likely need tweaking.
"It's stressed, but it's not dead," said Allan Roth, a Colorado Springs, Colorado-based certified financial planner and founder of Wealth Logic .
How a 60/40 portfolio strategy works
The strategy allocates 60% to stocks and 40% to bonds — a traditional portfolio that carries a moderate level of risk.
More generally, "60/40" is a shorthand for the broader theme of investment diversification. The thinking is: When stocks (the growth engine of a portfolio) do poorly, bonds serve as a ballast since they often don't move in tandem.
The classic 60/40 mix encompasses U.S. stocks and investment-grade bonds (like U.S. Treasury bonds and high-quality corporate debt), said Amy Arnott, a portfolio strategist for Morningstar.
Market conditions have stressed the 60/40 mix
Until recently, the combination was tough to beat. Investors with a basic 60/40 mix got higher returns over every trailing three-year period from mid-2009 to December 2021, relative to those with more complex strategies, according to a recent analysis by Arnott.
Low interest rates and below-average inflation buoyed stocks and bonds. But market conditions have fundamentally changed: Interest rates are rising and inflation is at a 40-year high.
U.S. stocks have responded by plunging into a bear market, while bonds have also sunk to a degree unseen in many years.
As a result, the average 60/40 portfolio is struggling: It was down 16.9% this year through June 30, according to Arnott.
If it holds, that performance would rank only behind two Depression-era downturns, in 1931 and 1937, that saw losses topping 20%, according to an analysis of historical annual 60/40 returns by Ben Carlson, the director of institutional asset management at New York-based Ritholtz Wealth Management.
'There's still no better alternative'
Of course, the year isn't over yet; and it's impossible to predict if (and how) things will get better or worse from here.
And the list of other good options is slim, at a time when most asset classes are getting hammered, according to financial advisors.
"Fine, so you think the 60/40 portfolio is dead," said Jeffrey Levine, a CFP and chief planning officer at Buckingham Wealth Partners. "If you're a long-term investor, what else are you going to do with your money?
"If you're in cash right now, you're losing 8.5% a year," he added.
"There's still no better alternative," said Levine, who's based in St. Louis. "When you're faced with a list of inconvenient options, you choose the least inconvenient ones."
Investors may need to recalibrate their approach
While the 60/40 portfolio may not be obsolete, investors may need to recalibrate their approach, according to experts.
"It's not just the 60/40, but what's in the 60/40" that's also important, Levine said.
But first, investors ought to revisit their overall asset allocation. Maybe 60/40 — a middle-of-the-road, not overly conservative or aggressive strategy — isn't right for you.
Determining the right one depends on many factors that toggle between the emotional and the mathematical, such as your financial goals, when you plan to retire, life expectancy, your comfort with volatility, how much you aim to spend in retirement and your willingness to pull back on that spending when the market goes haywire, Levine said.
While bonds have moved in a similar fashion to stocks this year, it would be unwise for investors to ditch them, said Arnott at Morningstar. Bonds "still have some significant benefits for risk reduction," she said.
The correlation of bonds to stocks increased to about 0.6% in the past year — which is still relatively low compared with other equity asset classes, Arnott said. (A correlation of 1 means the assets track each other, while zero connotes no relationship and a negative correlation means they move opposite each other.)
Their average correlation had been largely negative dating back to 2000, according to Vanguard research.
"It's likely to work in the long-term," Roth said of the diversification benefits of bonds. "High-quality bonds are a lot less volatile than stocks."
Diversification 'is like an insurance policy'
The current market has also demonstrated the value of broader investment diversification within the stock-bond mix, said Arnott.
For example, adding diversification within stock and bond categories on a 60/40 strategy yielded an overall loss of about 13.9% this year through June 30, an improvement on the 16.9% loss from the classic version incorporating U.S. stocks and investment-grade bonds, according to Arnott.
(Arnott's more diversified test portfolio allocated 20% each to large-cap U.S. stocks and investment-grade bonds; 10% each to developed-market and emerging-market stocks, global bonds and high-yield bonds; and 5% each to small-cap stocks, commodities, gold, and real-estate investment trusts.)
"We haven't seen those [diversification] benefits for years," she said. Diversification "is like an insurance policy, in the sense that it has a cost and may not always pay off.
"But when it does, you're probably glad you had it, Arnott added.
Investors looking for a hands-off approach can use a target-date fund, Arnott said. Money managers maintain diversified portfolios that automatically rebalance and toggle down risk over time. Investors should hold these in tax-advantaged retirement accounts instead of taxable brokerage accounts, Arnott said.
A balanced fund would also work well but asset allocations remain static over time.
Do-it-yourselfers should make sure they have geographic diversification in stocks (beyond the U.S.), according to financial advisors. They may also wish to tilt toward "value" over "growth" stocks, since company fundamentals are important during challenging cycles.
Relative to bonds, investors should consider short- and intermediate-term bonds over longer-dated ones to reduce risk associated with rising interest rates. They should likely avoid so-called "junk" bonds, which tend to behave more like stocks, Roth said. I bonds offer a safe hedge against inflation, though investors can generally only buy up to $10,000 a year. Treasury inflation-protected securities also offer an inflation hedge.