The traditional 60/40 portfolio, a staple of financial planning for decades, with a 60 per cent allocation to equities and 40 per cent to bonds, has been a simple and reliable strategy for investors seeking a balance between risk and return.
However, with the current economic landscape marked by higher inflation and interest rates, is it time to question the viability of this classic allocation model?
The changing financial landscape
The 60/40 model, a good but simple rule of thumb, has worked well in the past, primarily because of the nearly four-decade long bond bull market after the high interest rates of the 1980s decreased (until the past year turned the tide) and because of the negative correlation between stocks and bonds.
When stocks underperformed, bonds tended to perform better and vice versa, providing a cushion for the portfolio.
However, in this world that is different to the past 25 years, investors may need to reassess their beliefs.
For example, as inflation rises central banks typically respond by raising interest rates to curb inflationary pressures. This action directly impacts bonds, as their prices fall when interest rates rise.
A lower bond price occurs when interest rates rise because investors with spare cash can now earn more on newer higher yielding bonds, so the price of the existing lower yielding bond would need to fall to give investors a reason to want to buy it.
Consequently, the traditional role of bonds as a hedge against equity market volatility might be compromised in a higher inflation and interest rate environment.
Looking at nearly 100 years of data brings this to light.
The 2000 to 2021 period is the standout and makes us question whether we are simply reverting to what should be a more normal relationship between the two asset classes.
Assuming the outlook is for higher inflation and interest rates, what should you do for your clients in this world?
A shift in the portfolio allocation paradigm?
Some investors are considering reversing the traditional 60/40 allocation, that is, allocating 60 per cent to bonds and 40 per cent to equities.
This approach might appear attractive on face value, especially if one anticipates a period of stock market volatility or a stock market price downturn.
However, it is crucial to keep in mind that bonds would also face headwinds from rising inflation rates, and this means that bonds will more volatile than they have been in the past 25 years.
So, while higher interest rates are more attractive, investors need to balance a higher bond return against inflation and against achieving portfolio returns in the long run.
A directly linked topic is real returns. Directly explained, while bond returns are higher, this is because inflation has increased, so you may not always benefit as much as you think by allocating to bonds in this world.
The important aspect is about how much bonds provide after inflation is subtracted, as earning returns above inflation is what matters for wealth creation. Again, looking to the past nearly 100 years of data provides insights.
