The 60/40 Portfolio is Dead

The following first appeared on Money & Markets.

Responding to rumors that he had taken ill and died while on a speaking tour in Europe, Mark Twain told The New York Times: “The reports of my death are greatly exaggerated.”

Well, I don’t want to “greatly exaggerate,” but I think it’s fair to say that the 60/40 portfolio is dead. Or at the very least, it’s going to be on life support for a while.

It had a good run.

According to Vanguard, a portfolio invested 60% in stocks and 40% in bonds generated a compound annual return of 8.6% going back to 1926. That’s a stretch that includes the Great Depression, World War II, the stagflation of 1970s, the tech bubble and bust, and the 2008 meltdown.

It’s a portfolio that has clearly survived the test of time. And it’s easy to assume that it will continue to post numbers like these indefinitely.

Unfortunately, that doesn’t seem likely.

I’m no permabear and this isn’t an anti-buy-and-hold hit piece. I’m generally the optimistic sort, and when I err it’s usually on the side of being too aggressively invested, rather than too conservatively. But the numbers here are pretty straightforward. And they don’t look great.

Breaking Apart the 60/40 portfolio

We’ll start with the 60% invested in stocks, using the S&P 500 as a proxy.

As I wrote last month, the S&P 500 never got truly cheap during the coronavirus bear market. Yes, the market dropped 35% in record time, which brought it down to something closer to “fair value.” But at no point did it ever approach anything close to the valuation lows seen in previous bear markets.

Furthermore, those lows were short-lived. The market ripped higher in April, and today the S&P 500 is essentially at breakeven for the past 12 months.

The S&P 500 is trading at a cyclically adjusted price-to-earnings ratio (“CAPE”) of 26.5 today. If history were any guide, that would suggest annualized returns over the next decade to be close to zero.

Now, I’m the first to admit that historical comparisons should be taken with a grain of salt. Interest rates are lower today, which means that, all else equal, stock prices should be higher. The S&P 500 is also dominated by capital-light tech companies that should, all else equal, trade at higher valuations than clunky industrial firms.

I get all of that, which is why I think the S&P 500 will generate halfway decent returns over the next decade. But I still expect those returns to be lower than the historical average.

All About Bonds

But let’s say I’m wrong. Let’s say that it really is different this time and for reasons I can’t currently imagine, we really are in a period of permanently higher stock prices.

I actually don’t consider that idea to be crazy. Stranger things have happened.

But even if stock prices continue to push ever higher, there’s a big, gaping black hole where bond returns used to be.

The 10-year Treasury today yields 0.63%. A more diversified basket of bonds, such as the iShares Core U.S. Aggregate Bond ETF (NYSE: AGG) yields a little better at 2.6%. We’ll be generous and use that as our return assumption.

If we invest 40% of the portfolio in bonds, yielding 2.6%, and stocks generate 10% — which is generous given today’s valuations — that gets us a portfolio average of 7%.

That’s not all that bad. But again, it also assumes the market continues to perform in line with past returns, which is a stretch.

Let’s say instead that the stock market returns 5% per year going forward, rather than 10%. That knocks the returns of a 60/40 portfolio down to just 4% per year.

And let’s say the value investors are right and that stocks are priced to deliver essentially zero returns over the next decade. That knocks the return of a 60/40 portfolio down to just 1% per year.

This is why I really believe the 60/40 portfolio is dead, or at least dead for the next decade.

Again, this isn’t a bear hit piece. I’m not forecasting the stock market goes to zero or even that we retest the March lows. Maybe we do, maybe we don’t. Who knows.

Regardless, this should be a wake-up call. If your retirement planning “needs” an 8% return to be viable, you might need to consider working longer or cutting back some expenses.

You may also want to be a little more creative in your allocation. You can leave a good chunk of your investments in a 60/40 portfolio but also carve out some space for active strategies or for alternative investments, including gold or other precious metals.

But the worst thing you can do is carry on as if nothing has changed. Whether or not the 60/40 portfolio is dead, it’s certainly not priced to deliver the sorts of returns we’ve all become accustomed to.