Why 60/40 looks attractive again
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The classic investment portfolio of 60% stocks and 40% bonds is doing very well at the moment — it's risen 17% in the past year.
Why it matters: After more than a decade when interest rates were at or near zero, bonds provide real income again — without the volatility inherent to stocks. What's more, the capital losses involved when rates rise are now well in the past.
The big picture: Historically, one of the main reasons for a 60/40 portfolio was that stocks and bonds would provide natural hedges for each other. Stocks generally rise over time, but when they fall, that's because investors are "risk off" and seek safety — which is to say, they buy bonds.
The catch: The negative correlation between stocks and bonds — the reason why the 60/40 portfolio is considered well diversified — has been obliterated in recent years.
- Bonds and stocks both went down during the initial COVID crash, then both went up during the subsequent market rally, then both fell again when the Fed started hiking interest rates, and then both rose again when hopes were rekindled that inflation was tamed and rates would come back down.
- Effectively, stocks are increasingly being priced like bonds, with the present value of a stock calculated as its future cash flows, discounted at prevailing interest rates. When those rates go down, the value of a stock rises; when rates rise, it falls.
The other side: Just because the two asset classes are increasingly correlated, doesn't mean they don't still taste great together.
- Because rates are now high, bonds provide a healthy internal return in terms of their current yield. On top of that, if and when rates start to fall again, bonds have the capacity to generate significant capital gains.
- Meanwhile, stock-market valuations are looking stretched, which naturally reduces the rate at which stocks are going to be able to rise from here over the long term.
By the numbers: Add it all up, and U.S. bonds are expected to yield somewhere between 4.8% and 5.8% over the next decade, per Vanguard, compared to a range of 4.2% to 6.2% for stocks.
- If both bonds and stocks end up returning about 5.25% per year over the next decade, then finance theory says that bonds are the better option, because they're lower risk and therefore provide a higher risk-adjusted return.
The bottom line: Bonds won't always be this attractive, but no one is suggesting that investors move out of stocks entirely and into bonds. Instead, the idea is that a decent 40% allocation to bonds will make portfolios significantly less volatile — while still generating a healthy return.
