Rethinking the 60/40 Portfolio

From the 1980s until recently, a portfolio of 60% stocks and 40% bonds experienced a “golden age”—and for good reason. The mix consistently provided investors with attractive risk-adjusted returns, with total returns often equal to or better than those of the S&P 500 Index and with lower volatility.

But this strategy may no longer pack the same punch. Persistent inflation and growing recession fears have battered markets in 2022, providing strong headwinds to the 60/40 portfolio and prompting some critics to proclaim the “end” of the 60/40 as a useful investment strategy.

While we do expect the 60/40 portfolio to deliver lower risk-adjusted returns compared with those over the last four decades, that doesn’t mean it is broken. Morgan Stanley & Co.’s Chief Cross-Asset Strategist, Andrew Sheets, recently forecast a 10-year return of about 6.2% per year for the strategy, which is 3.9 percentage points above their forecast for inflation. The 60/40 may remain attractive for some investors, even as others may opt for a different strategy.

To determine the future of the 60/40 portfolio, it is important to understand:

• What drove the 60/40 portfolio’s stretch of relatively strong performance over the past four decades?
• Why does this remarkable success seem unlikely to persist at the same level going forward?
• How can investors pivot for the future?

Here’s our take.

• Slowing inflation:In the early 1980s, the Federal Reserve managed to stamp out high inflation from the prior decade, and with that came falling Treasury yields and lower correlations between stocks and bonds. This helped to provide attractive diversification and healthy total returns for both asset classes.
• Falling real yields: Yields tend to move inversely with asset prices. As inflation-adjusted, or “real,” yields gradually fell over the past four decades, stocks and bonds tended to benefit, as companies enjoyed lower costs of capital and higher valuations for financial assets.
• An accommodative Federal Reserve:Investors grew increasingly confident they could rely on a “Fed put”—central bank intervention aimed at ensuring liquidity in the financial system and containing market volatility. These actions led markets to believe the Fed would step in to limit damage during times of uncertainty.

Those favorable conditions are likely to fade, however, given the following:

• Normalizing inflation:Higher inflation levels could lead to a higher, positive correlation between stocks and bonds, which would reduce the potential diversification benefits of a stock-bond mix.
• Low but rising real yields:Real yields are likely to rise along with inflation, which would pressure bond prices and make stocks less attractive, likely leading to lower returns from the 60/40 portfolio.
• A less hands-on Fed:The Fed may be less willing and able to intervene in moments of market turbulence, removing a key support for asset prices.

Instead of taking on more equity risk to achieve similar returns as those seen from the 60/40 portfolio over the last 40 years, investors may want to consider other thoughtful strategies. These include:

• Tax-efficient investing:Investors can aim to increase after-tax returns by implementing strategies like tax-loss harvesting, or using realized losses to help offset capital gains for tax purposes.
• A mix of active and passive investing:Many investors prefer either passive strategies, which track an index, or active strategies, which attempt to outperform the index, but the two aren't mutually exclusive. Combining them in a portfolio and adjusting allocations in response to changing market conditions can be beneficial over time.
• Careful selection of asset managers:Investors may benefit from choosing high-quality asset managers across multiple asset classes and in different market environments, potentially boosting risk-adjusted returns in your portfolio.
• Diversification through hedged strategies:Certain types of hedged alternative investments can potentially reduce volatility and/or enhance returns in a portfolio.

Of course, sticking with a 60/40 allocation may continue to work for some investors. Indeed, the 60/40 portfolio may continue to deliver solid risk-adjusted returns. Bonds likely remain good diversifiers for stocks, helping to dampen the effects of volatility, even if they don’t offer the same degree of diversification as they did before.

Work with your Morgan Stanley Financial Advisor to determine which strategies may make the most sense for you considering your long-term investment goals. You can learn more inthis audiocastor by asking your Financial Advisor for a copy of the Global Investment Committee report,Sunset for 60/40?: Assessing Its Long-Term Success, Its Recent Struggles and Some Potential Pivots.

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