The world’s most ordinary investing strategy has just wrapped up an extraordinary decade by thumping the returns produced by the big brains at Yale and Harvard. But can a plain-vanilla 60/40 portfolio keep on delighting investors as markets get stormy and interest rates begin to rise?
The answer depends on what you want to achieve. If you’re shooting for the maximum possible return, or want to build an impenetrable defence against any possible loss, the 60/40 portfolio isn’t for you.
On the other hand, if you’re a typical investor looking for an intelligent, practical way to balance risk and reward, then this venerable approach demands your attention despite gathering storm clouds.
A 60/40 portfolio gets its name because it is composed of 60 per cent stocks and 40 per cent bonds. It reflects a simple observation: Stocks typically produce big profits over time, but with vicious downturns along the way. In contrast, bonds offer smaller rewards but produce those returns more reliably.
Mix the two and you should get an attractive blend of characteristics. So it turns out. In the U.S., a 60/40 portfolio would have generated an average annual return of 8.8 per cent between 1926 and 2017, according to Vanguard Group, the big U.S. money manager.
To be sure, an all-stock portfolio would have done a bit better, gaining an average 10.3 per cent a year. However, its added profits would have come at the cost of much deeper downturns.
For instance, the all-stock portfolio would have lost 43.1 per cent during its worst year of 1931, while the 60/40 balanced blend would have declined only 26.6 per cent – painful, yes, but far less miserable than the stocks-only approach.
For most people, the relative stability of the balanced portfolio makes sense. In exchange for a modest reduction in returns, you reduce your risk of truly horrible outcomes.
But is a 60/40 strategy the best you can do? In recent years, much of the investing industry has lined up against the concept.
Some critics say a 40-per-cent allocation to bonds is wasted money at a time when bonds produce little or no return after inflation. Other skeptics point out that a 60/40 portfolio offers only a partial haven when the stock market tumbles. It may reduce your losses, but it still goes down.
Rising interest rates pose a particular challenge to the 60/40 strategy right now. If borrowing costs bump up as expected over the next decade, the portfolio will be hit from two directions, because both bond prices and stock market valuations tend to move in the opposite direction to rates.
However, it’s not clear that any of the alternatives are much better. The financial industry touts the merits of hedge funds, private-equity deals, long-short portfolios and so on. However, these miracles of financial engineering are often opaque and complex – not to mention expensive. They don’t tend to welcome average investors. Worst of all, they sometimes flop.
For instance, the hedge funds covered by the standard HFRI benchmark have endured a mediocre decade and over the past 20 years have failed to produce any meaningful edge over the S&P 500 Index of large U.S. stocks. Meanwhile, private-equity returns have been less impressive than widely believed, according to a recent study by professors at Brigham Young University and Ohio State University.
In a paper entitled Private Equity Indices Based on Secondary Market Transactions, they found that a large portion of private-equity returns between 2006 and 2017 reflected nothing more than a bull market and large amounts of borrowed money. If you strip away those factors, the excess return generated by private equity funds was not significantly different from zero, the researchers concluded.
Even the smartest money in the world can struggle at times to keep up with a simple 60/40 portfolio. Consider Yale University.
In the 1990s, it pioneered a strategy that has since become the preferred approach for the endowments of many of the continent’s top universities and foundations. The Yale model consists of pouring money into opportunities that aren’t as thoroughly picked over as public stock and bond markets – areas such as timberland, hedge funds and private-equity deals.
In theory, this makes sense. Investors should derive a reward for taking on the additional work and risk that goes along with venturing into the dimmer corners of the financial markets. But in practice the Yale model has been inconsistent. It beat a 60/40 approach during its early years; more recently, it’s looked strictly ho-hum.
In fact, over the past 10 years, the endowments for Yale and all the other Ivy League schools in the United States failed to match the performance of a standard 60/40 portfolio, according to a recent study by Markov Processes International Inc., an investment research and software firm.
The 60/40 strategy would have generated an annualized return of 8.1 per cent from 2008 to 2018, according to Markov. The best an Ivy League endowment could muster over that period was the 8.03-per-cent-a-year performance of Princeton. At the bottom of the heap was Harvard’s endowment, which managed to eke out only a 4.5-per-cent annualized return.
It’s not often that an off-the-shelf investing strategy can beat the best minds of the Ivy League, so this result deserves attention. Maybe a few chuckles too. At the very least, it serves as a powerful reminder that simple strategies often work surprisingly well.
Ian McGugan