Supporters of the 60/40 style portfolio split, which aims to benefit from growth in equities while providing investors with downside protection in bonds, have noted that this investment strategy has collapsed very quickly this year. This article therefore aims to answer whether this is a permanent change or whether the performance of the 60/40 investment strategy will return to its long-term trend.

What is a 60/40 portfolio

For many years, a large percentage of financial advisors and securities traders created portfolios for their clients that consisted of 60% stocks and 40% bonds or other fixed income offerings. And these so-called balanced portfolios did quite well during the 1980s and 1990s.

How did such a portfolio perform in 2022

This year, however, investors have been surprised by the inability of bonds to act as a hedge against stock market declines. This was front and center in the third quarter, when a portfolio of 60% stocks and 40% bonds posted larger losses than a portfolio invested only broadly in stocks, an exceptionally unusual phenomenon.

The inability of so-called 60/40 portfolios to offer investors protection from a bear market in stocks has belied what has become conventional wisdom among markets: stock prices and bond prices do not move in the same direction. This thinking has been the basis of diversification strategies for many years. The stubbornly high inflation and the Federal Reserve's breakneck pace of interest rate increases this year have caused this significant shift in market behavior.

Instead of delivering an average return of 9%, this strategy has delivered a staggering return of minus 30% since the beginning of the year (see chart), the worst period in roughly a century, according to BofA Global.

"The classic 60/40 portfolio allocation with the largest weighting in stocks and a smaller weighting in bonds no longer makes sense," said Rick Rieder, chief investment officer for global fixed income at BlackRock Inc.

Will 60/40 start working again?

The question now is whether the relationship between stocks and bonds has undergone a permanent, secular change and, as a result, the abysmal performance of 60/40 portfolios will continue, or whether bonds will shift back to providing useful diversification against stock market losses. This is a question that is widely debated, with the outcome largely dependent on medium to long-term inflation trends. If inflation remains high, this could mean continued difficulty in 60/40 diversification. However, if the Fed gets inflation under control and if the economy falls into recession, bonds could return to their recent role as an offset to the stock market.

"Going forward, the dynamics will depend on what happens with inflation, and he notes that the Fed has already made it clear that inflation is its number one goal. If the Fed's actions can reduce uncertainty around inflation over time, then the negative correlation between stocks and bonds could return," said Hong Cheng, portfolio manager for performance-based strategies at Morningstar Investment Management.

Still, Cheng sees bonds providing value as part of investors' portfolios no matter what happens next. "With yields much higher than they were at the end of last year, we still see the value of fixed income in the portfolio - even if stocks and bonds continue to misbehave," he says. "During a recession, fixed income will provide a strong boost to the portfolio. As yields rise, bonds provide a firmer cushion."

DISCLAIMER: All information presented here is for informational purposes only and is in no way an investment recommendation. Always do your own analysis.