It’s not dead. It’s more important than ever.
I’m talking about the 60/40 portfolio, which has sometimes been considered the living heart of investing. These specific numbers – which refer to 60 percent stocks and 40 percent bonds as core investments – are not meaningful. They are only a practical starting point for thinking about investing and not a precise and general prescription for everyone. They never were either.
But they represent a fundamental principle. Although it’s more complicated, it boils down to this: don’t keep your eggs in one basket. Diversify rigorously and systematically across stocks and bonds, and do so over the long term.
Pretending that this concept is dead makes no sense. Investment diversification is more important today than ever, even if it has not borne fruit recently.
But what is true is that stocks and bonds have performed poorly for much of the past two years, including 2022. Soaring inflation and rising interest rates led to losses on bonds as well as a fall in the stock market. If you held a large portfolio of stocks and bonds in 2022 – whether your allocation was 60/40 or some other variation – you probably lost money. Neither stocks nor bonds helped.
It was horrible. But the solution is not to abandon diversification. It’s about sticking with it, and maybe even diversifying further.
The basic concept
Harry Markowitz was a financial giant. He was also a down-to-earth Chicagoan, who told me in 2012 that he was comfortable with the idea of using eggs in a basket to describe his work, for which he won a Nobel Prize in 1990.
“What I did was way fancier than that,” he said. “It took a lot of math.” But the basic concept is that if all your investments are the same and something bad happens to one of them, you’ll find yourself in, well, serious trouble. Don’t let this happen to you.
Harry died in June. In 2012, he explained how to reduce total risk by combining many individually risky assets. If their price movements are weakly correlated, or even inversely correlated – so that some go up while others go down – your portfolio will become more stable. This is the heart of what we now call “modern portfolio theory”.
It emphasizes asset allocation rather than selecting individual stocks and bonds, and only accepts risk that you can manage by selecting your investment allocation along what it has. called “an effective border”.
This is getting weird, but put simply, he advised building your portfolio for the long term, so you can ignore the constant financial crises that so many people on Wall Street obsess over.
Is the market up or down today? Don’t even think about it. It’s advice I’ve taken to heart.
But today, this fundamental approach to investing is under criticism. For what? The stock market, represented by the S&P 500, lost 18% in 2022. The bond market, defined by a popular benchmark, the Bloomberg US Aggregate Bond Index, lost 13%.
Diversification did not protect you in 2022.
Popularize the 60/40
Benjamin Graham, a finance professor at Columbia University who taught Warren Buffett about value investing, suggested in various editions of “The Intelligent Investor” that a portfolio of stocks and bonds should be at least 20% equity and possibly up to 80%. He opted for a 50/50 split, not 60/40, as a reasonable starting point, changing the stock split based on market conditions.
But 60/40 became reasonably popular in the late 20th century. Peter L. Bernstein, the economic historian, once explained the logic of a 60/40 allocation this way: Long-term investors should favor the stock market over bonds because stocks have a higher ceiling. high, but bonds are a balm because they are safer. So favor stocks, while holding a lot of bonds, keeping a 60/40 allocation, as a starting point.
John C. Bogle, the founder of Vanguard and the creator of the first commercially available broad, low-cost index funds, popularized the 60/40 portfolio as much as anyone when he created the Vanguard Balanced fund – a simple 60 mix /40. comprised of a broad Vanguard U.S. equity fund and a U.S. bond fund. (It lost almost 17% in 2022.)
Even Jack, as he insisted I call him, said 60/40 wasn’t the only solution. Vanguard’s oldest fund is a balanced fund, the Wellington Fund, which contains 65 percent stocks and 35 percent bonds. Other Vanguard funds have different allocations. All posted big losses in 2022, but have performed well over long periods.
So what mix is ideal? I don’t know. One idea is to own more stocks when you’re young and more bonds as you get older, although Jack himself didn’t do this. He took risks and held well over 60 percent of stocks in his personal portfolio, he told me, even though he was in his 80s.
The important question is not whether a 60/40 portfolio composition is the best solution. This may not be the case. But all traditional balanced portfolios are a mix of stocks and bonds seeking to reduce risk through diversification. And they are all open to the main criticism. Diversification has not worked well in 2022.
A bigger universe
One solution is to diversify even further. Both the Vanguard Balanced and Wellington funds are US-only funds. But modern portfolio theory suggests that you own a portion of the entire universe of publicly traded stocks and bonds.
In other words, go global. Use low-cost index funds (or actively managed funds, if you prefer) that span the globe. This is the approach I take and that academic finance generally recommends.
This didn’t help, however, if your goal is to minimize losses and maximize gains. U.S. stock and bond markets have outperformed the rest of the world’s markets for years. At some point, I suspect the situation will reverse and global diversification will pay off in the long run, as academic theory suggests. But that hasn’t been a satisfactory solution lately.
Another option is to expand beyond stocks and bonds. Probably the safest alternative is cash, which includes Treasury bills and money market funds.
They have performed remarkably well now that the Federal Reserve has raised short-term interest rates above 5% in its fight against inflation. Increasing your cash holdings and replacing some of your long-term bonds with money market funds has been an effective tactical move over the past couple of years, and cash can be considered part of a traditional core portfolio, even if it is difficult to find the right timing. .
To move from cash to longer-term fixed income securities, you need to pay close attention to interest rates and know when to enter and exit longer-term fixed income securities. It’s hard to get it right.
Another possibility is to modify your fixed income holdings in terms of duration, credit quality and nationality, although indexed holdings of investment grade bonds denominated in your home currency – the dollar, if you are American – may be enough.
Such readjustments may be appropriate for traditional and core investment portfolios.
But that’s about as far as I would go.
There are many other tempting alternatives.
Even those who favor core stock and bond portfolios have sometimes called for adding other asset classes – such as gold or real estate – to core diversified investments, even though some studies have shown that They offer, at best, minimal protection.
There is no shortage of reports from asset management firms claiming that hedge funds and private equity funds need to be added to the smart investor mix. And you can also delve into futures and options that can limit your losses, at some cost. Once you have embarked on this path, why not go further? Cryptocurrency: Industry players say this is an asset class that should be represented in your portfolio.
I haven’t seen strong evidence that any of these things are necessary as core investments. As an indicator of a simple 60/40 US-biased portfolio, consider Jack Bogle’s modest Vanguard Balanced fund. Certainly, its return was terrible in 2022: minus 17 percent. But since its inception in 1992, it has gained 7.8 percent annualized, a cumulative 900 percent. Over the past 12 months, this figure has increased by almost 10 percent. There’s nothing broken about this.
Stocks and bonds, for the most part, are not falling together this year. Diversification seems to be working again.
Of course, I can’t say what will happen in the future, and obviously the basic approach won’t always protect you from losses. But no one ever promised that would be the case.
Keep your costs low, invest broadly and stick to them. It’s a simple, proven approach. Despite painful lurches, there is good reason to believe it will work for years.