The 60/40 portfolio is an investment strategy that allocates 60% of assets to stocks and 40% to bonds. It was popularized based on the principles of Modern Portfolio Theory (MPT), which was developed by Harry Markowitz in the 1950s, who later received a Nobel Prize for this work. This allocation, combining stocks for growth and bonds for stability and income, has been a popular rule of thumb for creating a diversified and balanced portfolio that maximizes returns for each unit of risk, particularly for moderate-risk investors. The ratio was derived from the typical market composition at the time, reflecting the approximate market value ratio of stocks to bonds.
Over time, the 60/40 portfolio has been recognized for its simplicity, effectiveness, and historical performance, although recent market conditions and critiques of MPT's assumptions have led to discussions about its adaptability and the potential need for more dynamic investment approaches.
This chart illustrates the historical performance of the 60/40 portfolio, alongside its two components: the S&P 500 and a Total Return Bond Index, which is explained in more detail here. Please note that the S&P 500 is a price index in contrast to total return index. Therefore, it does not include dividends.
The correlation between stocks and bonds is one of the most important inputs to the asset allocation decision. However, it's important to understand that this correlation is not static and can change over time, primarily influenced by macroeconomic conditions and recessions. During periods of economic expansion and positive market sentiment, stocks generally perform well, resulting in a positive correlation with bonds. Conversely, during economic recessions, bonds often experience a rally due to both a flight to safety and central banks implementing interest rate cuts as a means to stimulate the economy. This leads to a situation where there is frequently a negative correlation between stocks and bonds during economic downturns.
The chart above displays the 1-year rolling correlation coefficient between the S&P 500 and and the Total Return Bond Index. A correlation coefficient of +1 indicates a perfect positive correlation, meaning that stocks and bonds moved in the same direction during the preceding time window. Conversely, a correlation coefficient of -1 indicates that stocks and bonds moved in opposite directions. In early 2022, the FED's decision to raise interest rates led to a simultaneous decline in both stocks and bonds, causing the 1-year rolling correlation to approach 1.
The correlation coefficient is important to consider for diversification because it helps investors assess the potential benefits of including both stocks and bonds in their investment portfolios. Diversification is the practice of spreading investments across different assets to reduce risk. In his book Principles, Ray Dalio called diversification the “Holy Grail of Investing”. He realized that with fifteen to twenty uncorrelated return streams, he could dramatically reduce the risks without reducing the expected returns.
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