Set-it-and-forget-it asset allocation has worked well over the long run, but that doesn't mean that investors can't use history as a guide in terms of avoiding near-term pain.
The traditional 60/40 split between stocks and bonds, respectively, has faded in and out of fashion over time, most recently dogged by rapid inflation, yet it remains the classic model for a portfolio.
That's probably because it's worked so well over recent decades. As Ben Inker, co-head of asset allocation at Jeremy Grantham's value-investing firm GMO, notes over the past 45 years, since the inception of the Bloomberg U.S. Aggregate Index, the 60/40 model has logged annualized returns of just over 10%, comfortably outpacing inflation and the needs of most investors. Taking it all the way back to 1900 still produces an annualized real return of 4.8%.
So far so good. But—and there's always a but—returns have deviated recently. Investors haven't minded of course, because it's meant even greater returns for them. In the most recent run-up from early 2009 through the end of 2021, a passively allocated 60/40 portfolio delivered about 9.4% annual real return, about twice the long-run average.
However, the law of averages suggests that, rather than entering a new era, there might be a reversion to watch out for. And in fact, as Inker highlights, history shows that, too.
Looking more closely at the 60/40's record shows that "that there have been six periods, averaging 11 years each, in which an investor in a 60/40 portfolio would have either broken even relative to inflation or, even worse, lost money in real terms," he writes. "Those chapters share something in common—they all followed exceptionally strong periods of return for the traditional portfolio and thus began when either or both stocks and bonds were trading at extremely high valuations."
If that's starting to sound uncomfortably familiar, it's because plenty of others have noted how expensive the stock market has become after its latest run, and the S&P 500's trailing price-to-earnings ratiois around 24 times. Interest-rate increases have made government bonds look reasonable, but Inker notes that an inverted yield curve may make it harder for bonds to earn more than cash: "Against this backdrop, reversion toward longer-term valuations would lead to very disappointing medium-term returns for a 60/40 portfolio."
That leaves investors with two options. The first is to simply ride things out, presumably with a long-term investment horizon. After all, it's worked for more than a century, and presumably will continue to over the decades to come.
Otherwise it could be time to play a little defense—as other strategists have also suggested. Inker writes that high equity valuations led GMO's Benchmark Free Allocation Strategy (BFAS) to reduce its exposure to stocks by a quarter, meaning much less pain during the downturn. Likewise, low valuations following the market plunge provided an effective buying signal; Grantham himself wrote about getting back into the market in March 2009, the start of the long bull market recovery.
Looking for cyclical opportunities is another option; that worked well during the early 2020 pandemic selloff, and today Inker writes that "exposure to Japan small-cap-value equity could prove very rewarding due to improving fundamentals and corporate reform efforts, favorable valuations, and an extremely cheap yen. A traditional 60/40 portfolio, holding about two thirds of its equity exposure in expensive U.S. equities, picks up little of this opportunity."
Barron's too has written about the positive changes that may finally be making Japan more attractive.
Looking farther afield applies to bonds too Inker notes, as investors could expand their pool to look at things such as high-yield, structured/asset-backed securities, and Treasury inflation-protected securities (TIPS).
Ultimately, those who use the traditional 60/40 model probably have reason to feel comfortable with their long-term prospects. Yet for those looking to avoid the down times built into those averages, it doesn't hurt to take a peek under the hood after the engine's been running hot.
Write to Teresa Rivas at teresa.rivas@barrons.com