The 60/40 Portfolio Is Under Threat. How to Defend It.

The crux of the problem is the changing correlation between stocks and bonds. If these are inversely correlated, then bonds appreciate when stocks sell off, making them a useful diversifier. That was the case from 2000 to 2021. But in 2022, the pattern broke. Stocks and bonds fell together, much to many investors’ dismay. What many missed is that in a period of high inflation, the Federal Reserve will hike interest rates to cool the economy, causing stocks and bonds to move down together. Runaway fiscal profligacy leads Treasury issuance to surge and increases the market term premium required to absorb bond supply, which again pushes stocks and bonds down together. This has happened recently.

If bonds and stocks go down together, the diversification benefit of 60/40 ebbs, and investors can be better off holding cash than bonds. But at the same time, policy impulses fluctuate, leading markets up and down, and holding too much cash can cause investors to miss out on opportunities from other assets.

There are steps investors can take to mitigate the risk that stocks and bonds will move together and harm a passive 60/40 portfolio. The solution lies in taking an active approach and adjusting 60/40 to an age of higher inflation volatility. First, investors need the ability to short assets in addition to being merely long only. When government policy pressures stocks and bonds down at the same time, investors must be able to hedge their portfolios against those risks.

Second, investors need the ability to manage their exposures to different tenors of fixed income and not simply hold long-dated, high-duration bonds. Long-dated bonds don’t work as a safety asset or diversifier when stocks and bonds are being pushed down by mountains of Treasury issuance and higher risk premia incorporated to assets. That kind of environment is also prone to rapid shifts by the Fed, which may cut rates if the combination of higher term premia and lower stock prices forces an economic slowdown.

In that context, short-dated bonds are a better safety asset, more likely to diversify because of their negative correlation to stocks. Since inflation may keep the next Fed cutting cycle relatively shallow, and short-term bonds’ prices tends to move less than longer maturities’, investors need a little leverage to provide sufficient diversification to stocks.

Third, investors must assess their own unique risk preferences and tolerances in the scope of any adjustments to 60/40. Taking short positions is risky, as are leverage and choosing specific nodes of the yield curve. Different investors will have different horizons and risk capacities, but flexibly responding to a changing environment can enhance long-run returns.

A smarter, active stock-bond-macro-alt portfolio that incorporates these changes can offer meaningful advantages over passive 60/40, even during periods of shifting correlations. Indeed, research shows that dynamically weighting stocks and bonds and adding some modest diversification with macro alternatives such as futures, commodities, and currency strategies has potential to deliver long-run returns competitive with equities, but with half the volatility, much shallower drawdowns, and half the time required to recover from drawdown.

While shifting correlations between stocks and bonds may spell trouble for a passive 60/40 portfolio, investors still have ways to own assets for the long run. An active strategic allocation with the ability to short and gain exposure to changing safety assets may be a sensible framework to deliver good performance compatible with an investor’s horizon and loss tolerance.

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