Don’t put your eggs in one basket. That investment principle still applies.
It’s not dead. It’s more important than ever.
I’m talking about the 60/40 portfolio, which is sometimes considered the living heart of investing. These specific figures – which refer to 60 percent equities and 40 percent bonds as core investments – are not significant. They are just a useful starting point for thinking about investing and not an exact, general recipe for everyone. They never have been.
But they do represent a fundamental principle. While it’s more complicated, it boils down to this: don’t keep your eggs in one basket. Diversify rigorously and systematically between stocks and bonds, and do this for the long term.
The claim that this concept is dead makes no sense. Diversification in investing is as important now as ever, even if it hasn’t paid off lately.
But what is true is that both stocks and bonds have performed poorly for most of the past two years, especially in 2022. Rising inflation and rising interest rates led to bond losses and a stock market decline. If you had a broad portfolio of stocks and bonds in 2022 – whether your mix was 60/40 or some other variation – you probably lost money. Neither stocks nor bonds helped.
That was terrible. But the solution is not to give up diversification. It means persevering and perhaps even diversifying further.
The core concept
Harry Markowitz was a financial giant. He was also an earthy Chicagoan, who told me in 2012 that he liked to use eggs in a basket to describe his work, for which he won a Nobel Prize in 1990.
“What I did was much better than that,” he said. “It took a lot of math.” But the basic concept is that if all your investments are the same and something bad happens to one of them, you’re, let’s say, in big trouble. Don’t let that happen to you.
Harry died in June. In 2012, he explained how to reduce overall risk by combining many individually risky assets. If their price movements are poorly or even inversely correlated – so that some rise while others fall – your portfolio becomes more stable. This is the core of what has become known as ‘modern portfolio theory’.
It emphasizes asset allocation over individual stock and bond selection, and only accepts the risk you can handle by selecting your investment mix along what he called “an efficient frontier.”
This is going to be weird, but in simple terms he recommended setting up your portfolio for the long term so you can ignore the ongoing financial crises that obsess so many people on Wall Street.
Is the market up or down today? Don’t even think about it. That’s advice I’ve taken to heart.
Now, however, this core approach to investing has come under criticism. Why? The stock market, as represented by the S&P 500, lost 18 percent in 2022. The bond market, defined by a popular benchmark, the Bloomberg US Aggregate Bond Index, lost 13 percent.
Diversification will not protect you in 2022.
Popularize 60/40
Benjamin Graham, the Columbia University finance professor who taught Warren Buffett about value investing, suggested in several editions of “The Intelligent Investor” that a stock and bond portfolio should consist of at least 20 percent stocks and perhaps as much as 80 percent. . He chose a 50/50 split, not 60/40, as a reasonable starting point, adjusting the stock allocation depending on market conditions.
But 60/40 became quite popular in the late 20th century. Peter L. Bernstein, the economic historian, once explained the logic of a 60/40 allocation this way: Long-term investors should choose the stock market over bonds because stocks have a higher ceiling, but bonds are a balm because they are safer. So choose shares while holding many bonds, using a 60/40 allocation as a starting point.
John C. Bogle, the founder of Vanguard and the creator of the first commercially available, broad, low-cost index funds, made the 60/40 portfolio as popular as anyone when he created the Vanguard Balanced Fund – a simple 60/40 mix of a broad American Vanguard equity fund and an American bond fund. (It lost almost 17 percent in 2022.)
Even Jack, who insisted I call him, said 60/40 wasn’t the only choice. Vanguard’s oldest fund is a balanced fund, the Wellington Fund, and it contains 65 percent stocks and 35 percent bonds. Other Vanguard funds have different allocations. They all had big losses in 2022 but have done well over long periods of time.
So which mix is ideal? Don’t know. One idea is to hold more stocks when you’re young and more bonds as you get older, although Jack hasn’t done that himself. He liked to take risks and had more than 60 percent of the shares in his personal portfolio, he told me, when he was well into his eighties.
The important question is not whether a 60/40 portfolio mix is the best. Maybe not. But all traditional balanced portfolios are mixes of stocks and bonds that attempt to reduce risk through diversification. And they are all open to the main complaint. Diversification did not work well in 2022.
A bigger universe
One answer is to diversify even further. The Vanguard Balanced and Wellington funds are both US-only funds. But modern portfolio theory suggests that you own a slice of the entire investable, publicly traded stock and bond universe.
In other words: go global. Use low-cost index funds (or actively managed funds, if that’s your preference) that span the entire planet. That is the approach I take and that Academic Finance generally recommends.
However, it won’t help if your goal is to minimize losses and maximize profits. The US stock and bond markets have outperformed the rest of the world markets for years. At some point I assume that this will change and that global diversification will pay off in the long term, as academic theory suggests. But it hasn’t been a satisfactory solution lately.
Another option is to go beyond just stocks and bonds. The safest alternative is probably cash, including government bonds and money market funds.
They have performed admirably as the Federal Reserve has raised short-term interest rates above 5 percent in its fight against inflation. Increasing cash holdings and replacing money market funds with some of your longer-term bonds has been an effective tactical move over the past two years, and cash can be considered part of a classic core portfolio, although determining the right timing is tricky . .
If you want to switch between cash and longer-term fixed income investments, you need to pay close attention to interest rates and know when to get in and out of longer-term fixed income investments. It’s hard to get that right.
Another option is to tailor your fixed income investments in terms of duration, credit quality and nationality, although investment grade indexed investments in bonds denominated in your home currency (dollars, if you are American) may be all you really need has.
Such adjustments may be appropriate for traditional, core investment portfolios.
But that’s about as far as I’d go.
Alternatives
There are many more tempting alternatives.
Even those who favor core stock and bond portfolios have sometimes called for adding other asset classes – such as gold or real estate – to diversified core investments, although some research has shown these provide minimal protection at best.
There is no shortage of reports from asset managers claiming that hedge funds and private equity funds should be added to the mix of intelligent investors. And you can also look into futures and options that can limit your losses for a fee. Once you’ve started this route, why not venture further afield? Cryptocurrency: People in the industry argue that it is an asset class and should be represented in your portfolio.
I haven’t seen solid evidence that these things are needed as core investments. As a benchmark for a simple US-focused 60/40 portfolio, consider Jack Bogle’s modest Vanguard Balanced fund. It is true that the return in 2022 was terrible: minus 17 percent. But since its inception in 1992, it has added 7.8 percent annually, or a cumulative 900 percent. In the past twelve months it is up almost 10 percent. There’s nothing wrong with that.
For the most part, stocks and bonds are not falling simultaneously this year. Diversification seems to be working again.
Of course, I can’t say what will happen in the future, and it’s clear that the core approach won’t always protect you from losses. But no one ever promised this would happen.
Keep your costs low, invest widely and stick with it. It’s a simple approach and a proven approach. Despite painful problems, there are good reasons to believe it will work for years to come.