What is 60/40? Investing explained

In this series, we break down the jargon and explain a popular investment term or theme. Here it is 60/40.

What is this?

For more than 50 years, the belief has been that the perfect investment portfolio consists of 60 percent stocks and 40 percent bonds.

This standard allocation model was considered ideal for individuals, pension funds and other institutions that wanted diversification and some protection against volatility. Some advocated a 50/50 split, but the 60/40 model prevailed.

Who came up with this?

American economist Harry Markowitz devised the strategy in 1952 as part of his celebrated “Modern Portfolio” theory.

It is said that the 96-year-old Nobel laureate did not expect his idea to be considered gospel and may not have applied the principle to his own money, but it is uncertain whether these claims have any validity. See hmarkowitz.com for more information.

What is the reason behind this?

The performance of bonds and stocks should be ‘uncorrelated’. That is, when stocks rise, bond prices fall and vice versa.

Bonds also provide a reliable source of income in addition to dividend payments. During a period known in stock market circles as ‘The Great Moderation’, the mix has stood the test of time, with decent returns and some degree of protection against risk.

During the dot-com crisis, bonds softened the blow of the fall in stock prices.

So what happened in 2022?

Portfolios with the 60/40 mix fell as much as 20 percent. Stocks and bonds tumbled in unison as interest rates in the US and UK were raised and inflation soared due to the energy crisis. Rising interest rates depressed stock prices, particularly those of technology companies. Meanwhile, inflation wreaked havoc on bond values.

What was the impact on investors?

Many were unprepared. But some institutions had moved away from 60/40 as academics highlighted its shortcomings.

They claim it was designed for a different era when small shareholders rather than institutions dominated stock markets, and before issues such as ESG (environment, social and governance) drove stock selection decisions.

Is it RIP for 60/40?

At the start of the year, many commentators argued that it was no longer relevant and should be consigned to history.

But 60/40 still has its enthusiasts. They claim that while 2022 was a dismal year, 60/40 is a proven formula over the long term and will make a comeback in 2023.

These supporters have been encouraged by signs that inflationary pressures are easing. Investors are returning to bond funds, attracted by the returns on offer.

How can I diversify now?

A broad diversification of UK and international stocks and bonds still makes sense.

But 60/40 critics argue that you should also have had money in infrastructure, real estate and private equity, i.e. privately held companies. These are held by a number of private equity investment trusts.

The experience of 2022 shows that it can be dangerous to buy and hold and assume that things will work out.

This may be the case eventually, but there may be sleepless nights along the way.