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What is a 60/40 portfolio and why is it a good strategy?

2022 was a challenging year for the 60/40 portfolio. High levels of inflation around the world, rapidly rising interest rates and slowing economic growth induced significant volatility in the financial markets. Positive investment performance was tough to find but this strategy in particular succumbed to the weaker economic outlook.

In this series, we will begin by establishing what a 60/40 portfolio is and who it may be for, then moving on to the finer details of the poor recent performance. Finally, we will explore the kinds of performance we can expect from a 60/40 portfolio as we move through different market cycles before providing you with our final view on the matter.

What is a 60/40 portfolio?

A 60/40 portfolio is one consisting of 60% equities and 40% bonds. This would make it suitable for an investor with a moderate appetite to risk. The equities would typically be the main driver of capital appreciation, while the bonds are expected to provide some yield or income but are also heavily relied on to offset some of the losses if equity markets fall.

The long-term returns from this investment approach have been good. Research from J.P. Morgan Asset Management shows a 60/40 split of US stocks and bonds returned 11.5% annualised since the global financial crisis. Going back to 1980 and the average annual return for the strategy is 10.6%. This was despite seven negative years, and average intra-year drops of -7.7%.

The challenges of 2022 have certainly affected performance resulting in a fall of 16.1% in the first half of this year. The dot com crash and global financial crisis stand out as other points where investors would have seen negative annual returns, however, very little performed well during these periods. What makes 2022 unique is the negative performance of both components of the portfolio – something we have not seen before.

Historically reliable returns

So, what is it about bonds and equities that have historically made them a good combination? The appeal of the strategy is the lack of correlation between the assets, or, put another way, the diversification a mix of assets brings. If equities fall, bonds should provide some support, similarly if bonds are falling equities would be grinding out positive returns. This held true even through the financial crisis.

These different asset classes tend to react differently to economic conditions and so offset the risk each investment takes. For example, in the middle of a business cycle, when the economy is growing, equities will benefit from the positive levels of spending so perform well. Interest rates often rise to keep inflation close to the 2% target set by the Bank of England. This can spell out a tough period for government bonds.

Higher interest rates challenge government bonds. If an investment has an income, or yield, of 5% and interest rates move up from 1% to 3% then the extra return for holding a bond is reduced. A smaller return relative to cash means the price should fall.

As we move further through the economic cycle rising rates can cause the economy to contract, so equities won’t perform well due to consumers restricting spending. We therefore tend to see equity investments fall when the rate rises eventually slow the engine of economic growth.

Market cycles affect returns

The timing of peaks and troughs in equities and bonds can vary. Equities tend to fall more than bonds, and bonds may fall first, only to rise when equities catch up. We call this ‘sequencing.’

Generally, as the economy slows government bonds offer support as investors looks to more secure assets, which lifts demand and prices. Demand can also pick up as investors begin to price in the prospect of interest rates falling, to stimulate economic growth in the economy.

Most of the time markets follow this sequence of events, although each time the cycle is slightly different. The dot com boom of the early ‘00’s saw technology stocks bear the brunt of the sell off and in the global financial crisis in 2007-08 banks over-extended themselves as rates rose to control the economy. In 2022 rates have risen, but this time it is different we have had a shock due to the war in Ukraine.

Our next article in this series looks at why 2022 was particularly difficult for equities and bonds.

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This is not a financial promotion and is not intended as a recommendation to buy or sell any particular asset class, security or strategy. All information is correct as at the date of publication unless otherwise stated. Where individuals or FE Investments Ltd have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice.

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