Based on many years of reviewing investor portfolios, I concluded that most end up closely resembling a 60% Stocks / 40% Bonds Allocation. Yes, many portfolios also have alternatives, nuanced sub-asset classes, individual security selection, and perhaps some tactical components. But when you look at their returns, a simple 60/40 can usually explain 99% of these more diversified allocations. (This persists even if investors have a different high level allocation, like a diversified 40/60 - in this case a simple 40/60 will explain the majority of the more complicated allocations.)
Because of its popularity, in this post, we review the 60/40 through a couple lenses that we at Two Centuries use when thinking about the long-run properties of an investment.
The Cone Chart
This is an excellent way to visualize long-run performance versus expectations of return and risk. We demonstrated its effectiveness for Value and Momentum here.
During the last 95-years, the long-run 60/40 return is powerful at 9.7% per year. One dollar invested in December 1925 would be $5,555 today.
This is why standard financial advice goes like this: “hold on to your portfolio because over the long-run the compounding will kick in and do its magic.”
Sources: Morningstar, Ibbotson, CFA Institute, Two Centuries Investments
The Two Risks That Ruin Long-Term Investing
Why do so many investors end up not earning 9.7% over the long run? Evidence here, here, here and here.
The primary reason is the fear of crashes and the second is the worry about low-expected returns. (See more about these two risks here. And read about the ways investors behave trying to avoid the pain of these two risks here.)
The primary reason investors miss out on long-term compounding is fear of the crash risk, which is embedded in a 60/40 portfolio through its heavy equity and credit risks.
The 60/40’s max crash was -69% during the 1930’s. But until the 2008 crash, few investors chose to seriously consider such long history. Today, as historical data is becoming more popular (for example here and here), we can use these historical drawdowns to set more accurate expectations about the future.
If your total portfolio more or less resembles a static 60/40 allocation, you should be ready for a 70% crash at some point in the future.
I realize that in some ways this sounds too simplistic: just because the 60/40 had a 70% drawdown once in the 1930’s, why should we expect it again in the future?
Yes, the actual future max drawdown could be better or worse. But expecting the 70% loss builds in a lot more resiliency into investor’s expectations than the current situation. Most financial advisors talk about volatility instead of max losses. And even when max losses are mentioned, they are at best reviewing the hypothetical losses during the 2008 scenario which was much safer than the Great Depression. Increasingly, I see even 2008 being dropped as it has conveniently exited the 10-year look back window. In sum, investors in balanced portfolios are far from expecting anything close to a 70% potential loss and this results in negative surprises along the way which cause investors to start ‘tweaking’ their strategies.
The reality is that when your prospect client asks for a balanced portfolio and you show them a ‘once in a century’ 70% loss, they will likely not become your client. To me, avoiding this conversation is analogous to the ‘head in the sand’ approach. The potential crash risk is still there, no matter if you choose to think about it or not.
The second reason investors don’t earn the attractive long-run 60/40 return is ironically their worry about 60/40’s low expected returns. During the past decade and increasing recently, the argument that the expected return for the 60/40 is way too low became widely accepted and that has derailed a lot of portfolios. These expected return forecasts proved wrong and have cost investors a huge amount of missed compounding.
Looking at the 10-year rolling annualized return graph above, there is nothing unusual during the past 10 years. After reaching a low decade return of 2.99% per year in February 2009, the returns bounced back and gradually recovered towards their long-run average. The ‘low 60/40 expected return’ argument started to surface around 2011 when it was used to hard-sell an alternative asset allocation called Risk Parity. See more on chasing diversifies here.
Even the 10-year peak of 13.6% per year reached in 2019 looks normal compared to the prior peaks and subsequent returns. Since then, realized 10-year return has decreased to 9.64% which is almost exactly the long-run average.
The long-run expected return forecasts for the 60/40 are rather misleading by how accurately they appear to predict future returns. More-so, they are not feasibly implementable. And even if the low expected return forecast happens to be correct over any given decade, it does not mean that the alternative portfolio would behave any better. In sum, the ‘low-expected-return’ argument has been rather destructive during the past decade to most portfolios that acted on that argument.
Solutions
Asset owners appear to have five choices:
Static simple 60/40 allocation via ETFs / balanced fund provider.
Static diversified allocation by a financial advisor which ends very similar to 60/40.
Alternative asset allocation like Risk Parity, Endowment, Factor-Based.
Dynamically ‘do-it-yourself’, trying to avoid crashes and increase returns.
Dynamic asset allocation manager whose approach you understand, so you can stick with it during the turbulent times.
At Two Centuries, we serve clients by doing the latter in our Dynamic Balanced strategy.