60/40 Portfolios May Bounce Back

Key Takeaways

The traditional 60/40 balanced stock/bond portfolio had its worst year since the Great Depression in 2022. In most down years, stocks alone are to blame. But what made 2022 so destructive was that both stocks and bonds fell sharply.

Last year’s painful outcome left many investors asking whether the 60/40 portfolio is still a valid investment approach. We understand this concern, but we don’t think one year — even a historically bad one — invalidates a strategy that has produced attractive risk-adjusted returns over time.

With yields at their highest point in a decade, bonds are much better positioned than they were a year ago, in our view. Based on our research, we also think the environment will be less conducive to the stock and bond markets moving in tandem. As the performance of these asset classes diverges, we believe bonds are likely to demonstrate their diversification and risk-reduction benefits once again.

Poor Bond Performance Was the Real Story in 2022

Figure 1 charts the historical performance of stocks, bonds and the combined 60/40 portfolio. The dashed lines in the chart show performance trends over the past 40 years. This helps clarify the role each asset plays in achieving the goal of a combined portfolio: generating solid returns with less risk than an equity-only approach.

You can see in Figure 1 that stocks have historically been growth drivers, while bonds have delivered lower returns with less volatility. Indeed, for the 40-year period, we found that the traditional balanced portfolio captured much of the U.S. equity market performance with significantly less volatility.

But 2022 was different. Not only did stocks produce double-digit losses, but bonds, as measured by the Bloomberg Barclays U.S. Aggregate Bond Index, posted a historic decline. Simultaneous and extreme declines in stocks and bonds like these are rare. You can see this in Figure 2, which shows how much stocks, bonds and the 60/40 portfolio have deviated from their historical performance trends over time.

This analysis is historically important because it demonstrates the abnormal performance of bonds in 2022. Therefore, we don’t think investors should abandon the time-tested 60/40 approach because of this single episode.

Bond Performance Is Essential to 60/40 Effectiveness

Bonds have traditionally played two roles in the classic, balanced portfolio:

• Generating some portion of the portfolio’s total returns (not as much as equities’ contribution).

• Reducing portfolio risk.

Looking first at returns, bonds have gained an average of 2% per year over the past 40 years after accounting for inflation. The secular decline in yields since the early 1980s provided an extra return benefit because bond prices rise as yields fall. The tailwind of falling yields reversed in 2022, and yield increases were entirely responsible for the steep decline in bond prices.

But looking ahead, we think conditions are brighter. The benchmark 10-year U.S. Treasury note yield is now at the highest level in over a decade. In addition, we believe slowing inflation and the likelihood of a recession in 2023 indicate that bond yields are more likely to fall than rise.

Regarding risk reduction, we know from history that bond returns have tended to be positive when stock returns have been negative. However, this wasn’t the case last year because stock and bond prices fell in tandem. To understand why stocks and bonds moved together in 2022, we analyzed correlations over the last 30 and 60 years.

Fed Policy Stability Helps Determine Stock/Bond Correlation

As shown in Figure 3, we found that the degree to which stocks and bonds rise and fall together (correlation) is highly dependent on monetary policy stability. During periods when Federal Reserve (Fed) policy is evolving quickly (high change), stocks and bonds tend to move together. This tendency helps explain the high correlation between stock and bond performance in 2022 when the Fed raised rates seven times.

Conversely, correlations are lower when monetary policy is more stable (low change). During such periods, economic changes influence stock and bond prices more than Fed policy.

Breaking out correlations in this way highlights the extent to which rapid and unexpected changes in Fed policy have caused correlations to converge during crisis periods. Results are directionally the same whether we look at the past 30 or 60 years.

Figure 3 | Stock and Bond Correlations Rise When the Fed Is Active

Stock and Bond Correlation

^{Source: American Century Investments. The S&P 500® Index represents stocks. The Bloomberg Barclays Aggregate Bond Index represents bonds. *We classified rolling three-month periods into either “high change” or “low change” periods, using a 0.4% threshold for changes in the one-year Treasury yield as a proxy for market views on Fed policy. Correlation is expressed in a range from 1 to -1, with 1 as perfectly correlated, -1 as negatively correlated and 0 as no correlation.}

Staying the Course With 60/40

We can use our research results to help set expectations for relative stock and bond price behavior in the months ahead. Since the Fed appears to be succeeding in its quest to quell high inflation, we believe 2023 should provide a comparatively more stable monetary policy. As a result, we expect correlations to fall and bonds to return to their beneficial risk-reduction role in a classic, balanced portfolio.

Stock and bond risk and return relationships change over time. And these portfolios aren’t immune to negative results. But on average, these asset classes have complemented each other over long periods.

So even though 2022 was difficult for investors, we see it as a bump in the road, not a reason to change course.

We believe stock/bond correlations will likely decline as we move away from a period of extreme Fed action. Instead, asset class performance and correlations should reflect underlying economic fundamentals once again.