Balancing Risk and Reward: A Modernized 60/40 Portfolio

Investors have faced a challenging environment in 2022. Concerns about recession, inflation, and volatility punished stocks, while bonds offered little relief as the Federal Reserve raised short-term interest rates to combat inflation. Against this turbulent backdrop, investors across the spectrum of skill and experience are concerned about the growing risks to their portfolios.

However, revisiting a few fundamental concepts can help simplify the modeling, managing, and communication of portfolio risk. Data gathered from thousands of investment portfolios of the financial professionals with whom we work can help identify potential risks in portfolios. At the same time, insights from our multi-asset investment professionals can help navigate today’s challenges with a strategic, modernized approach to portfolio construction.

“Understanding and managing portfolio risk in relation to investor risk tolerance can be a complex task under any market conditions, and it’s especially difficult today,” according to Sébastien Page, head of Global Multi-Asset and CIO for T. Rowe Price, in a recent Portfolio Construction webinar. “With inflation proving sticky and the Fed tightening monetary policy in response, now may be a great time to review the foundations of portfolio construction to gain a better understanding of risk.”

Many investors understandably are concerned about current market and economic uncertainty. However, their portfolios frequently don’t reflect those concerns accurately through a potentially lower-risk investment approach. Let’s look at portfolio beta—a common measure of volatility, where a number greater than 1 indicates higher risk versus a benchmark and a number less than 1 indicates lower risk.

Our proprietary database of financial professionals’ model portfolios shows that moderate risk portfolios—those with a 60% allocation to stocks and 40% to bonds—had an average beta of 1.05 versus the benchmark Morningstar Moderate Target Risk Index. Importantly, betas of 1.10 or higher appeared in about one-third of moderate models, while betas of 1.00 or less (indicating similar or lower risk than the benchmark) appeared in only about one-fourth of models.

“When we took a deeper look at the asset class level, we found that financial professionals increased weights to small- and mid-cap stocks in search of better return potential,” says John Escario, a specialist on our Portfolio Construction Solutions team. “However, the increased volatility risk from equities usually was not offset by increasing or adjusting bond allocations.” Allocations to bonds with lower duration, which measures sensitivity to interest rates, and diversification into non-core fixed income sectors, such as high yield and emerging markets bonds, have been popular ways to address the risk of rising interest rates. However, these assets are often less effective at offsetting increased equity risks elsewhere in the portfolio.

“Setting clear expectations for risk and return, looking beyond traditional measures of risk, and applying a modern lens to the asset mix in your portfolio design can help address some of these issues,” Escario suggests.

Figure 1 summarizes recent research from our Global Multi-Asset team. Over the 30 years prior to the market disruptions related to 2020’s COVID pandemic, stocks averaged a 10.0% annualized return and bonds generated 5.9%. These resulted in a relatively robust 8.3% annualized return in a typical moderate risk portfolio of 60% stocks and 40% bonds.

Current market and economic conditions, however, suggest future returns for stocks and bonds may be more subdued. Using the Shiller CAPE and Siegel models, stocks are likely to generate 7.4% over the coming five to 10 years, and bonds are forecast to return 3.7%. This would result in a 5.9% return in a typical 60/40 portfolio. “Based on today’s reality, the bottom line is pretty clear,” explains Page. “Investors may need to lower their return expectations going forward.”

Looking at Figure 1 from another perspective reveals another striking insight. Investing in a 60/40 portfolio over the 30 years through 2019 required only a 2% allocation to stocks to generate a 6% overall return. In contrast, our analysis suggests investors would need a 62% exposure to stocks to achieve the same 6% target return over the coming five to 10 years. There is some good news, however: In the fall of 2021, a similar analysis suggested investors would’ve needed 85% exposure to stocks in a 60/40 portfolio to generate that 6% return. Market conditions changed dramatically over a relatively short time period and, in this instance, helped to improve the potential of the 60/40 portfolio for many investors.

When combining building blocks like stocks and bonds into a broader investment portfolio, it’s important to look beyond traditional measures of risk. Asset class correlations, for example, are typically not stable over time. Research¹ suggests that most risk assets become extremely correlated during market selloffs and tend to have low correlations during market rallies. As a result, diversification should be represented by more than simply long-run correlations, and risk management should account for exposure to loss when markets are stressed.

What does all of this mean for the traditional 60/40 portfolio blueprint? To borrow a phrase from Mark Twain, news of its demise may be greatly exaggerated.

Figure 2 illustrates an example of a modernized 60/40 portfolio. Within the fixed income allocation, investors could consider carving out about 12% to alternative investments. “In many ways, this is similar to what we see financial professionals doing,” offers Escario. “But the role and fit of these alternative investments matters.”

In this case, there may be an opportunity to maintain the broader allocation to bonds but introduce a lower volatility profile that’s geared more toward absolute returns. In addition, a barbell approach could pair long-maturity U.S. Treasuries to help mitigate economic growth shocks with emerging market bonds and floating rate bank loans to help diversify interest rate risk.

Within equities, there could be a tilt towards diversifiers such as small- and mid-cap stocks and emerging market equities. Investors could also consider a risk-managed equity sleeve that embeds tail-risk hedging strategies to make up for the loss of diversification from Treasuries during rising rate or inflationary periods.

“It’s time for our industry to rethink portfolio construction,” concludes Page. Applying these concepts can help simplify the modeling, managing, and communication of portfolio risk in order to help improve long-term asset allocation decisions and maximize results for the end investor.