Why Inflation and Rising Interest Rates May Be a Problem for 60/40 Portfolios

For 70 years, investors, especially those with retirement in their sights, have poured trillions of dollars into the 60/40 portfolio mix. The thinking behind it is that 60% invested in stocks drive the returns while 40% invested in bonds provide the ballast during volatile markets, with both assets forming the core building blocks of a long-term portfolio. Despite ongoing predictions of the decline of 60/40, for much of the last several decades, the strategy of investing 60% in stocks and 40% in bonds has held up well, generating positive returns in 11 of the last 12 years.

Why change now?

If the portfolio’s performance final quarter of 2021 is any indication, this may be the end of the venerable asset allocation mix. The portfolio posted losses in September, November, and December as inflation was spiking, and the Federal Reserve signaled a significant shift in its rate policy. Both stocks and bonds reacted poorly, indicating a higher correlation between the two that doesn’t bode well for the 60/40 portfolio.

Since then, there have been several instances of simultaneous losses by domestic stocks, corporate bonds, and government bonds, raising the risk flag that many investing experts have been talking about. The prospect of higher interest rates may make it difficult for bonds to carry their role as a defensive hedge. And, with bonds yielding less than the inflation rate, investors could abandon high-quality bonds for short duration bonds and cash equivalents, further driving down bond prices.

The demand by investors for higher yield could eventually spill into equities. But with the stock market teetering on the high valuations of U.S. large-cap stocks and facing headwinds from rising interest rates, equity investors could also be looking at prolonged mediocre investment performance.

The Risk of Low or Negative Total Returns

Many experts are forecasting low, single-digit returns over the next decade for the stock market. Vanguard has downgraded its forecast for 60/40 returns to less than 4% in median annualized returns through 2031, driven largely by declining bond prices. An increasing number of asset managers are now concerned about an extended period of negative total returns.

It’s important to remember that 60/40 is only a rule, and rules are made to be broken. It was developed 70 years ago under very different economic and market conditions. During the last 30 years, it performed very well due to a historic bull market in bonds that appears to have ended. So, while bonds wonderfully outperformed in their ability as a volatility hedge, it may be time to look at alternatives.

Total Return Alternatives for Bonds

Among the often-mentioned alternatives for bonds are utility stocks, which have a record of growing their earnings while paying a nice dividend. Though they too can be sensitive to rising interest rates, they offer a higher total return than bonds.

High-quality dividend-paying stocks are another favored alternative. Companies with a track record of paying dividends every year and raising them periodically can be counted on as a source of income and moderation in an otherwise volatile equities portfolio. Real estate investment trusts (REITs) are also a reliable source of steady dividend payouts, and they tend to absorb inflationary pressures better than other investments.

The 60/40 allocation mix had a very good run. However, for investors seeking steady total returns, it may require a rule adjustment but one that is consistent with their investment objectives, time horizon, and risk profile. In terms of risk and volatility, we believe it’s not a significant adjustment to go from a 60/40 stock and bond allocation to a 60/20/20 stock, bond, and alternative allocation, such as a high-quality dividend stock and REIT allocation, or some combination of both.

Investors considering any asset allocation strategy should always seek the guidance of an investment advisor who can objectively assess appropriate allocation solutions based on their circumstances, objectives, and risk tolerance.


https://www.amazon.com/Boomer-Investing-Perilous-Decade-2020s-ebook/dp/B093N8FVJY/ref=tmm_kin_swatch_0?_encoding=UTF8 18 April 2022

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