60/40? I Can't Even

Vanguard senior investment strategist Todd Schlanger made the rounds in two places over the weekend, Barron's and Yahoo Finance trying to defend the 60/40 allocation. 

From Barron's, "Sticking with the 60/40 strategy still makes sense...Despite steep losses in 2022, when stocks and bonds both fell, a 60/40 portfolio has returned over 20% since then, which should portend continued strong future returns." And in Yahoo, "It's a very diversified strategy and we think it's poised to do very well in the future."

The reason I am bagging on this, well there are quite a few reasons but first is there is no sort of forward looking anything, actually no sort of assessment of current conditions either. In both articles he offered a tweak of 60/40 in terms of incorporating foreign exposure as follows.

It doesn't back test very far because of BNDW. I tried to find an older Total World bond fund and struck out so please leave a comment if you know one that is older. Here are the results.

That the foreign blend lagged, doesn't matter because foreign equities have lagged by a lot lately. Foreign exposure is valid of course, but any portfolio heavy in foreign had lagged domestic only for the last few years so that is fine. This issue here is that there's no differentiation. They correlate closely. Someone who wants 60/40 stocks bonds and wants to include foreign? Then it's a fine portfolio.

But as we've looked at countless times, bonds no longer offer the diversification benefits they once did. I'm not sure they ever did actually because all the data that we can look at is skewed by a 40 year run where bond yields went from 15% down to a low of 58 basis points on the ten year US Treasury. That cannot be repeated. Whether 2022's bear market was a reversion to some sort of mean or something else, that event broke the 60/40 portfolio as it's commonly applied because it changed the correlation relationship between stocks and bonds. 

Mark Rzepczynski touched on this in a very short blog post, he said;

A switch from a -.5 to +.5 will double the volatility of a 60/40 stock/bond mix based on historical data. Think about it. You will see your portfolio can move from single to double digit risk while keeping the allocation the same. There will still be a diversification benefit from bonds, but you will have to live with more risk. Back to basics, the correlations across assets matter. 

Diversification can be thought of as a management of correlations and understanding when correlations change, all the better if you can understand why they changed.

As opposed to bonds being thought of as the diversifier to equities, they are maybe better thought of a diversifier. What's one thing we always say? Diversify your diversifiers. Equities are the thing that go up the most, most of the time. Asset class diversification can help ease the volatility of equity exposure as well as make a portfolio more robust when equities get pasted or otherwise struggle. 

This really isn't that 60/40 is dead, more like 40 into bonds is a bad idea. 60% stocks, maybe 10% bonds, 10% managed futures, 10% in an absolute return strategy that looks like what people hope bonds look like and 10% into some sort of diversified macro strategy is better? That's just an example, I don't have anywhere near 10% in bonds with any sort of duration but in the context of not all diversifiers can work all of the time, 10% in bonds isn't the end of the world just because they are not working. Maybe they will work again? If yields go down to 3%, then bonds will do well but taking that on with 40% of a portfolio doesn't make a lick of sense to me. 

So let's try that, 60/10/10/10/10 using Todd's equity idea.

The return stream isn't that differentiated, except when you needed it to be. 

No one needs diversification, until they need it if you take my meaning. 60/10/10/10/10 looks a lot like 60/40 every year except 2022 when it was down 7.19% versus 16.87% for VBAIX. Some of the portfolio stats really stand out too in favor of 60/10/10/10/10 despite 10% in what I think is about the last place you want to invest these days, bonds with duration. Replacing AGG with floating rate would increase the CAGR by 54 basis points and lower the standard deviation by 46 basis points with a smaller decline in 2022.

Yes, I've been harping on this bond thing for ages, since long before 2022. Ten or 15 years ago it was more about yields not compensating for the potential volatility, then it became more about yields at all time lows only being able to go up even if I didn't know when or if that would happen and now it is about bonds being unreliable diversifiers. This is a theme that has played and evolved over the course of many years. 

Who knows if ten or 20 year paper could ever get to 8% again. Although I think that is unlikely, all of the volatility and risk that bondholders might have to put up with to get 4% now, might be worth it at 8% or maybe 7%. There is some level, we all need to decide for ourselves what level, where the volatility would be worth it but not at 4%, 5% and probably not 6%. We can reassess if we ever see 7%. 

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.