The 60/40 Portfolio and Why Diversification is the Holy Grail of Investing

FOMO is No Way to Invest

Let’s do a little time travel. Imagine it’s 2015, and you’re an active investor. 2014 was the year of stocks. By the year’s end, Dow rose 7.5%, S&P 500 rose 11.4%, and NASDAQ rose 13.4%. 

If you were a savvy stock-picker with all of your capital invested in stocks, you must have been pleased with the returns. But if you were a conservative proponent of “keeping your eggs in different baskets” (also known as diversification), you’d have been miserable with moderate returns. 

In years like 2015 (following the returns in 2014), going all-in on equities (or high-performing stocks) seems to be the only reasonable choice. It feels almost foolish not to put everything you have in them. But nothing lasts forever – at least not market conditions. And the fear of missing out on high returns leads to return chasing, one of the biggest mistakes an investor can make.

If you want good stable long-term returns, betting big on one investment is often the worst mistake you can make. Putting all your eggs in one basket can mean losing a lot of money all at once when things go south. This is why most professional investors bet on diversification when building long-term portfolios.

What is Diversification?

The term diversification is pretty self-explanatory. It simply means investing in different types of assets to build a portfolio that is not too concentrated, both in terms of risks and returns.

Diversification protects your investment portfolio against sudden and unexpected changes in market environments. 

The idea behind diversification is simple yet powerful: you cannot be sure about the future so it’s best to hold different assets that position you for many possible future market conditions.

In short, diversification is one of the best ways to reduce your portfolio’s risk while keeping returns stable. 

What is Risk and How Diversification Reduces It

Risk, in the context of investments, refers to the possibility that the actual return of any of your investments may be lower than what you expected. This may also mean losing some or all of the capital you invested in an asset. 

Types of Risk in Investments

There are two types of risks:

• Loss of investment capital, which can be temporary or permanent
• Volatility, or the standard deviation of price changes of assets. The higher the standard deviation, the more the asset price fluctuates.

You should expect higher returns from assets with higher risk/volatility. An asset is not a good investment if it is risky and does not have commensurately high returns.

You can regulate the amount of risk and return that comes from any asset by controlling how much capital you allocate to it. For example, if you have $100 and invest it all in equities, you will get 100% of the returns of equities as well as 100% of the risk/volatility of equities.

How can diversification reduce your portfolio’s risk? Diversification distributes the risk in a portfolio across several asset classes that react very differently to any given market environment.

For example, equities and bonds usually react oppositely in a given market environment (e.g., when growth comes in above or below expectations). Holding both assets together will insulate the portfolio better against future market environments compared to holding just one of the two assets.

Diversification is similar to preparing for a trip to a surprise destination. You don’t know what the weather will be so you pack everything from summer shorts to sweaters and umbrellas. Sweaters won’t help if your destination is super hot, but your shorts will be perfect. And if it rains, you’ll have umbrellas to protect you.

The way asset classes move relative to each other is measured using correlation. When two asset classes move independent of one another, they have little to no correlation. When they move opposite to each other, they have negative correlation. And when they move similarly, they have high correlation. Typically, investing in assets with low or negative correlation balances your portfolio well and reduces risk.

How Investors Typically Diversify Portfolios And Why It’s Not Working Anymore

As an investor, there are two primary ways you can achieve diversification:

• Diversify within asset classes
• Diversify across asset classes‍

For optimal diversification, you should diversify within and across asset classes.

Diversifying Within Asset Classes

One of the most straightforward types of diversification comes from holding multiple stocks in large-cap U.S. companies using an S&P 500 ETF such as VOO. Why does it work?

Because even though S&P 500 are all equities, they do not always behave the same. Company-specific factors play an important role in stock prices. As a result, these stocks do not have perfect lockstep movement; they do not react to any given market situation in exactly the same way.

In other words, since stocks are not perfectly correlated with each other, having a broad mix of stocks helps reduce risk. This is why long-term investors generally prefer broad-based equity indices such as the S&P 500 over a small concentrated basket of stocks.

Investing in multiple components within the same asset class (a basket of stocks, for example) can protect you against the fall in any one stock. While this is far better than betting everything on one stock, it does not help if equities as a whole start performing poorly relative to expectations. That’s where diversifying across asset classes can help.

Diversifying Across Asset Classes

Different asset classes react differently to any given market environment. Typically, investors diversify across two asset classes: nominal bonds and equities.

As a rule, stocks do well in periods where growth comes in above expectations or inflation comes below expectations. Nominal bonds perform well when growth and/or inflation come below expectations.  Since equities and bonds are usually inversely or negatively correlated, when equities do well, bonds do not, and vice-versa. A portfolio with a mix of these two is generally considered diversified and well-balanced in terms of risk.

Even if one asset class does poorly due to a sudden market shift, the other will buffer the portfolio and provide more stable returns. The portfolio won’t have extreme gains or losses in any given period. Instead, the annual returns will be more consistent than a portfolio made of just one asset class.

That’s why diversifying across asset classes results in a portfolio that does well in most market environments.

Diversification With Bonds and Equities: Increasing Returns, Decreasing Risks

Imagine four different investment portfolios:

• Portfolio A (All Stocks) has all its capital in stocks. 100% of its risks and returns are dependent on stocks. 
• Portfolio B (60 / 40) has 60% of its capital in stocks and 40% in bonds. The returns for this one will be slightly lower than Portfolio A’s, but its risk will be significantly lower. 
• Portfolio C (25 / 75) has 25% stocks and 75% bonds. Again, returns are lower than the previous two, but risk is also significantly lower. 
• Portfolio D (All Bonds) has 100% bonds. In this case, not only are the returns lower, but the risk is also higher than for Portfolios B and C.

Why is Portfolio D more risky than Portfolios B and C despite the 0% allocation to stocks? Because even though bonds are less risky than equities, a 100% bond portfolio has no diversification. If market conditions change such that the economic growth is above expectations, such a portfolio won’t do well and will be very risky.

We reduce risks in portfolios B and C by allocating more capital to bonds. Bonds are less volatile, so they are far less risky than stocks. B is a standard investment portfolio, whereas C is preferred for older investors nearing retirement. A and D are the riskiest out of all (D is less risky than A) because they are not diversified.

Balancing an investment portfolio in this way has long been a favorite of both retail and institutional investors. Portfolio B is typically called the 60/40 investment portfolio.

What is 60/40?

60/40 is an investment strategy where you allocate 60% of your portfolio’s capital to equities and 40% to bonds. It’s straightforward and flexible. And it works well because stocks and bonds are negatively correlated in most market environments, which means the portfolio benefits from diversification.

60/40 is the Goldilocks portfolio – it is neither too good nor too bad in terms of both returns and risk in any market environment. Yet, it generally has one of the highest quality returns relative to risk (more on this in future posts) that is available on the market today.

Why Does 60/40 Work?

Here are some reasons why 60/40 has done well for some time and continues to be a favorite for many investors.

Advantages of 60/40

Simple and Diversified

60/40 portfolios are simple yet highly diversified; most 60/40 portfolios invest in the S&P 500 and a basket of U.S. government bonds. This type of portfolio is diversified both within and across asset classes.

Since equities and bonds are inversely correlated, this portfolio provides stable returns when economic growth comes above or below market expectations. Bonds do well when growth falls, and equities do well when it rises.

Over the last four decades in the US, economic growth has been above expectations and stable, while inflation has remained consistently at or below expectations. Because of this, the 60/40 portfolio has worked well.

Low Tracking Error

60/40 has a lower tracking error to popular U.S. stock indices such as the S&P 500. This gives investors peace of mind, especially when the indices are performing well, because they are not missing out on stock market returns.

Easier to Build and Manage

60/40 is easy to manage because it has fewer assets. Several ETFs and mutual funds have 60/40 as their inherent composition, which means all you have to do is invest in one of these. There is little to no active management required.

60/40 portfolios have performed well for the last few decades because of:

1. Highly accommodative monetary policies
2. Low and stable inflation
3. Low and stable commodity prices
4. Robust growth
5. Rising P/E multiples driven by technology innovations

Therefore, it is a good starting point for do-it-yourself retail investors unfamiliar with more complex financial engineering.

Disadvantages of 60/40

Despite the above-mentioned pros, the 60/40 strategy is far from optimal. There are a couple of reasons why:

Improperly Risk-Balanced

60/40 puts too much of your portfolio’s risk in the hands of equities. Even though you invest only 60% of your total capital in equities, the risk of the portfolio is dominated by them because equities are far riskier than bonds. This means that a 60/40 portfolio is not diversified enough risk-wise because the risk is still too concentrated on one asset class. 

Example: If you invest $10 in stocks and $7 in bonds, it seems like you’re distributing the risk fairly between the two. But the only thing being distributed is the capital. Since stocks are significantly riskier than bonds, your portfolio is more risk-dependent on stocks; your portfolio will be largely dependent on how stocks perform since stocks are much more volatile than bonds.

With a 60/40 portfolio, returns will also take a slight hit if economic growth comes below expectations.

Not Immune to Changing Market Environments

Markets do not fluctuate solely based on changes in growth. An often overlooked driver is inflation. In any market, four possible situations can occur relative to expectations: rising growth, rising inflation, falling growth, and falling inflation.

A 60/40 portfolio offers virtually no protection against rising inflation. Equities and bonds help create a diversified portfolio when growth is the primary market driver.

A 60/40 portfolio does not do a good job hedging an investor against risk in such an environment.

Lack of Geographical Diversification

60/40 portfolios are usually not geographically diverse. Few people invest in non-U.S. stocks and bonds using this method. This reduces the portfolio’s geographical diversification and increases its risk exposure.

If the U.S. does poorly relative to expectations, portfolios concentrated in U.S. assets will underperform. Therefore, it makes sense to have a geographically diversified portfolio over the long haul.

Unattractive Returns

60/40 does provide a decent return but not one as good as a portfolio with 100% equities would.

Moreover, due to low-bond yield environments that have unfolded in the past few years, bonds are not providing attractive returns. Investing such significant capital in them right now would cause you to miss out on more rewarding investment options. 

Some of these weaknesses of a 60/40 portfolio, particularly unattractive returns for the amount of risk it has, can be improved by enhancing the portfolio using the type of financial engineering commonly used by hedge funds and institutional investors.

With financial engineering, it is possible to spread the risk more evenly between the two asset classes, matching bond risk allocation to that of stocks.

Is a Financially Engineered 60/40 Portfolio the Optimal Portfolio?

In recent times, inflation has come in well above expectations globally. The Fed misjudged inflation and was forced to tighten monetary policy suddenly and dramatically. As a result, equities and nominal bonds are declining in value in tandem, with their correlation approaching one. In such situations, assets like commodities do pretty well. But 60/40 does not allocate to commodities.

In other words, a financially engineered 60/40 portfolio still fails to address geographical diversification and inflation-driven market environments.

Investors cannot rely on just equities and bonds to achieve optimal long-term returns anymore. It’s time to construct an even more diversified portfolio that overcomes the shortcomings of a traditional 60/40.