Is the 60/40 portfolio dead?

July 21, 2023 | 12 min read
Han Peng, CFA
Quantitative Strategist
Raj Singh, CFA
Portfolio Manager, Asset Allocation

The “60/40 portfolio” (60% stocks, 40% bonds) suffered a historically bad run in 2022, prompting many market practitioners to question...is the 60/40 portfolio construct dead? With the stock/bond correlation rising sharply in just a few months, the diversification benefits and alpha potential of the 60/40 dwindled, hurting both the strategic construct and tactical asset allocation of multi-asset portfolios. Fixed income yields were hovering near historic lows, providing limited cushion for 60/40 portfolios against losses in equities, especially as it was accompanied by rising interest rates. Yet, an examination of inflation and growth dynamics suggests that the elevated stock/bond correlation is likely temporary and should normalize lower as inflation stabilizes. Lowered stock/bond correlation and higher fixed income yields suggest that the fundamental construct of the 60/40 portfolio remains attractive.

Diminishing diversification benefits

60/40 portfolios have delivered 9.4% annual returns over the last five decades, only marginally below the S&P 500’s 10.9% return, but with much lower volatilities. For investors with a more limited risk budget, or for those who sought out a potentially more consistent investment experience, the 60/40 portfolio has been quite an attractive option. Why has the 60/40 portfolio historically offered better risk-adjusted returns than the S&P 500? The diversification benefit—which is mainly driven by low stock/bond correlations.1 When stock/bond correlations are low, the diversification benefit is high, and vice-versa.

Since 1973, there have been five instances when the S&P 500 delivered an annual loss of more than 10%—the 60/40 portfolio outperformed the S&P 500 in each instance. In 2022, however, with heightened stock/bond correlations, the returns of equities and fixed income fell in tandem amid market meltdowns. Combined with already low starting bond yields, this created an environment where, despite still outperforming the S&P 500, the 60/40 portfolio recorded its second-largest annual loss since 1973.

Performance divergence when equity drawdown is greater than 10%
60/40 versus S&P 500

Bar char of 60/40 vs. S&P 500 comparing performance divergence when equity drawdown is greater than 10%.

Source: Bloomberg, Principal Asset Management. Data as of December 31, 2022. Inception date: January 31, 1973. Strategic Allocation: 60% S&P 500, 40% Bloomberg U.S. Treasury. Returns are gross and in USD without taking any without taking any transaction cost and alpha assumptions into accounts. Portfolio is rebalanced to the target weight on a monthly basis. Past performance is not an indicator of future performance. Not to be taken as investment advice. Actual returns may vary significantly from modelled returns.

Unsurprisingly, 2022’s abysmal performance has raised the chorus of “the death of the 60/40 portfolio,” with investors concerned that multi-asset portfolios’ stability benefits and the asset allocation alpha potential are significantly and fundamentally reduced. What made this statement popular was the low yield environment preceding the 2022 selloff, and some market participants’ belief that the recent inflation increase was a regime shift that would permanently increase stock/bond correlations. Before concluding that the 60/40 portfolio is dead however, it’s important to examine the stock/bond correlation drivers for better insight into whether the recent correlation rise is a temporary or long-term structural shift.

Stock/bond correlation and diversification benefits
1976–present

Line graph of stock/bond correlation and diversification benefits from 1976-2023.

Note: Correlations are between S&P 500 and Bloomberg UST Index. Diversification benefits defined as volatility reduction of 60/40 portfolio.
Source: Bloomberg, Principal Asset Allocation. Data as of June 30, 2023.

Stock/bond correlation dynamics

Although stock and bond performance are subject to many different forces, the two most important macro factors are economic growth and inflation. These two factors work differently for stocks and bonds, shaping their correlation landscape over time.

In a simplified model, when an economy grows rapidly, stocks typically benefit from stronger corporate earnings and higher dividends and therefore deliver better returns. Strong economic growth, however, leads to higher bond yields, which causes bonds to underperform. Alternatively, when inflation is high, central banks are typically raising interest rates to increase funding costs and curb demand, which is detrimental for both stocks and bonds. Effectively, economic growth moves stock and bond prices in opposite directions, while inflation, whether positive or negative, moves stock and bond prices in the same direction.

Using industrial production as a proxy for growth and consumer prices as a proxy for inflation, data from the last five decades (January 1973 – May 2023) shows that for every 1% increase in economic growth, stocks rose by 1.1% and U.S. Treasury bonds fell by 0.3%. By contrast, for every 1% increase in inflation, stocks fell by 0.5% and U.S. Treasury bonds fell by 0.2%.

Historic trends

Before the 2000s, particularly in the ’70s and ’80s, inflation and interest rates were considerably more volatile. Large swings in inflation and rates played a more significant role in determining various assets’ performance and resulted in higher correlations and lower diversification benefits. In contrast, the inflation and rate environments were more stable from the late 1990s to 2010s, which made economic growth cycles more important to asset class performance, lowering stock/bond correlations.

The economic environment of 2020-2022, with its large swings in inflation and rates, resembles the ’70s-’80s period more than the last two decades. Consider: The COVID crisis led to a short deflation period, with Fed funds rates cut to zero in one month. A strong recovery and quick rebound in aggregate demand followed. By 2021, with inflation skyrocketing, the Federal Reserve (Fed) chose to respond in force, and since March 2022, investors have witnessed the most aggressive Fed hiking cycle since the late 1980s, with 500 bps of rate increases in 15 months. Given the characteristics of the 60/40 portfolio, these swings resulted in rising correlations, stocks and bonds falling together, and drove 60/40 performance to a near-historic low.

Stock/bond correlation versus U.S. inflation
By decade, 1970–present

Bar chart of stock/bond correlation vs. U.S. inflation from 1970-2023 by decade.

Note: Correlations are between S&P 500 and Bloomberg UST Index.
Source: Bloomberg, Principal Asset Allocation. Data as of June 30, 2023.

The path forward

Since late 2022, both flexible and sticky components of U.S. inflation are trending lower, despite the sticky components proving slow to normalize. Easing supply chain bottlenecks, lower commodity prices, and the weakening economic growth outlook are all weighing on consumer prices. Given that the drivers of inflation's rapid increase over the last two years are unlikely to repeat, investors should expect a more stable inflation environment ahead.

Flexible versus sticky inflation
3-month annualized rate, 2001–present

Line graph comparing flexibly and sticky inflation from 2001-2023 at a 3-month annualized rate.

Source: Atlanta Fed, Bloomberg, Principal Asset Management. Data as of June 30, 2023.

Receding inflation and the Fed approaching the end of its hiking cycle suggest the macro environment will likely put downward pressure on stock/bond correlations. Indeed, the uncertainty around the growth outlook presents a challenging environment for investors, illustrated by market expectations jumping between hard landing and soft-landing scenarios during the first half of 2023. As a result, stock/bond correlations have started to fall—adding fuel to the argument that 2021-2022 was an anomaly rather than a permanent shift in the correlation regime.

Thanks to higher interest rates, investors are getting much higher compensation for taking interest rate risk compared to 2021-2022. Bond yields are now much higher, providing better carry (income) and a cushion for potential future losses in bond prices. The higher carry currently offered by bonds increases the utility of bonds in a 60/40 portfolio, as it provides mitigation against losses in equities.

In short, the demise of the 60/40 portfolio seems overly exaggerated, and the higher stock/bond correlations in 2022 appear to have been more of a speed bump than a permanent shift in trajectory. In fact, since the market shock in 2022, falling stock/bond correlations combined with the highest bond yields since the Global Financial Crisis have restored the 60/40 multi-asset portfolio construct back to its historical reputation as an appealing option for investors seeking risk-adjusted returns.

1 The diversification benefit can be defined as the percentage reduction in the volatility by a 60/40 portfolio compared to weighted average of equity and fixed income volatilities. It manifests in the way that 60/40 portfolios typically lose less during market drawdowns.

Disclosure

Risk considerations
Investing involves risk, including possible loss of principal. Past performance is no guarantee of future results. Asset allocation and diversification do not ensure a profit or protect against a loss. Inflation and other economic cycles and conditions are difficult to predict and there Is no guarantee that any inflation mitigation/protection strategy will be successful. Fixed-income investments are subject to interest rate risk; as interest rates rise their value will decline. Equity investment options involve greater risk, including heightened volatility, than fixed-income investment options.

Important Information
This material covers general information only and does not take account of any investor’s investment objectives or financial situation and should not be construed as specific investment advice, a recommendation, or be relied on in any way as a guarantee, promise, forecast or prediction of future events regarding an investment or the markets in general. The opinions and predictions expressed are subject to change without prior notice. The information presented has been derived from sources believed to be accurate; however, we do not independently verify or guarantee its accuracy or validity. Any reference to a specific investment or security does not constitute a recommendation to buy, sell, or hold such investment or security, nor an indication that the investment manager or its affiliates has recommended a specific security for any client account. Subject to any contrary provisions of applicable law, the investment manager and its affiliates, and their officers, directors, employees, agents, disclaim any express or implied warranty of reliability or accuracy and any responsibility arising in any way (including by reason of negligence) for errors or omissions in the information or data provided.

This material may contain ‘forward-looking’ information that is not purely historical in nature and may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.

This material is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation.

This document is intended for use in:

  • The United States by Principal Global Investors, LLC, which is regulated by the U.S. Securities and Exchange Commission.
  • Europe by Principal Global Investors (Ireland) Limited, 70 Sir John Rogerson’s Quay, Dublin 2, D02 R296, Ireland. Principal Global Investors (Ireland) Limited is regulated by the Central Bank of Ireland. Clients that do not directly contact with Principal Global Investors (Europe) Limited ("PGIE") or Principal Global Investors (Ireland) Limited (“PGII”) will not benefit from the protections offered by the rules and regulations of the Financial Conduct Authority or the Central Bank of Ireland, including those enacted under MiFID II. Further, where clients do contract with PGIE or PGII, PGIE or PGII may delegate management authority to affiliates that are not authorised and regulated within Europe and in any such case, the client may not benefit from all protections offered by the rules and regulations of the Financial Conduct Authority, or the Central Bank of Ireland. In Europe, this document is directed exclusively at Professional Clients and Eligible Counterparties and should not be relied upon by Retail Clients (all as defined by the MiFID).
  • United Kingdom by Principal Global Investors (Europe) Limited, Level 1, 1 Wood Street, London, EC2V 7 JB, registered in England, No. 03819986, which is authorized and regulated by the Financial Conduct Authority ("FCA").
  • United Arab Emirates by Principal Global Investors LLC, a branch registered in the Dubai International Financial Centre and authorized by the Dubai Financial Services Authority as a representative office and is delivered on an individual basis to the recipient and should not be passed on or otherwise distributed by the recipient to any other person or organization.
  • Singapore by Principal Global Investors (Singapore)Limited (ACRA Reg. No. 199603735H), which is regulated by the Monetary Authority of Singapore and is directed exclusively at institutional investors as defined by the Securities and Futures Act 2001. This advertisement or publication has not been reviewed by the Monetary Authority of Singapore.
  • Australia by Principal Global Investors (Australia) Limited (ABN 45 102 488 068, AFS Licence No. 225385), which is regulated by the Australian Securities and Investments Commission and is only directed at wholesale clients as defined under Corporations Act 2001.
  • This document is marketing material and is issued in Switzerland by Principal Global Investors (Switzerland) GmbH.
  • Hong Kong SAR (China) by Principal Asset Management Company (Asia) Limited, which is regulated by the Securities and Futures Commission. This document has not been reviewed by the Securities and Futures Commission.
  • Other APAC Countries/Jurisdictions, this material is issued for institutional investors only (or professional/sophisticated/qualified investors, as such term may apply in local jurisdictions) and is delivered on an individual basis to the recipient and should not be passed on, used by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation.
  • Nothing in this document is, and shall not be considered as, an offer of financial products or services in Brazil. This presentation has been prepared for informational purposes only and is intended only for the designated recipients hereof. Principal Global Investors is not a Brazilian financial institution and is not licensed to and does not operate as a financial institution in Brazil.

Insurance products and plan administrative services provided through Principal Life Insurance Co. Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc. Securities are offered through Principal Securities, Inc., 800 547-7754, Member SIPC and/or independent broker/dealers. Principal Life, Principal Funds Distributor, Inc., and Principal Securities are members of the Principal Financial Group®, Des Moines, IA50392.

© 2023, Principal Financial Services, Inc. Principal Asset ManagementSM is a trade name of Principal Global Investors, LLC. Principal®, Principal Financial Group®, Principal Asset Management, and Principal and the logomark design are registered trademarks and service marks of Principal Financial Services, Inc., a Principal Financial Group company, in various countries around the world and may be used only with the permission of Principal Financial Services, Inc.

3010654
About the author