Portfolio allocations: Is 70/30 the new 60/40?

Increasingly, traditional portfolio allocations of 60% equity risk and 40% bond risk are migrating to 70/30. It’s happening for a couple of understandable reasons, unintentional and by design: Outperforming stock markets and underperforming bonds markets have moved portfolio weights in the absence of proactive rebalancing; and investors (and their advisers) have sought higher return and risk allocations to make up for the ending of a 40-year bull market in bonds. 

The Federal Reserve’s quick actions in March 2020 to bring short-term interest rates to zero and pump $120 billion a month into fixed-income markets also brought down mortgage rates and longer-term bond coupons. The 10-year Treasury yield dropped to 0.53% in August 2020, which had the effect of punishing savers and rewarding risk-takers. The complementary $5.5 trillion fiscal support healed consumer balance sheets and further fueled investing in homes and other risk assets. None of this was a surprise or unintended, and a 70/30 stock-bond investment portfolio was an easy, comfortable consequence.

We generally think of the risk in financial markets, particularly with stocks and bonds, as being symmetrical: The upside and downside risks are more or less equal in magnitude at any point in time. So the average size of the drawdown or upside outperformance is important in assessing risk in portfolios. We have also seen an increase in the historical spreads between average stock and bond market performance: 

• Over the last 70 years the S&P 500 has averaged approximately 11.3% with annualized standard deviation (risk) of 15%, and the index of investment-grade bonds (AGG) has averaged 5.9% with 3% standard deviation.

• Since the stock market bottom on March 9, 2009, through the end of September, the S&P 500 has averaged 17.5% even with a 34% market correction in February and March of 2020, while the AGG has averaged only 3.8%. 

• Over the past year through Oct. 14, the S&P 500 is up 28% while the AGG is down 1.7% 

The AGG and Treasury bonds were helpful when equity markets were down 34% in February and March of 2020, but stocks rebounded quickly and ended the year up 18.4%, with bond returns trailing off and turning negative as interest rates bounced back up. The S&P 500 was also up 31.5% in 2019, making it easy for portfolio allocations to migrate from 60/40 to 70/30 somewhat unnoticed amid the extraordinary market fluctuations.

While equity and fixed-income markets have delivered respectable performances over the past 70, 20 and 12½ years, the average investor has typically generated less than one-half of a 60/40 portfolio return or less, than investing only in bonds, as a result of being in and out of the market, running to or from rising or falling returns, capturing the biggest declines and missing the biggest gains. This is a topic for another conversation but speaks to the importance of having a plan and sticking with it.

DOES IT MAKE SENSE FOR 70/30 TO BE THE NEW PLAN?

The outlook for traditional fixed-income returns is more challenging than encouraging. We see it with the AGG being down over the past 12 months. The 10-year Treasury yield has risen 1% since August 2020 which means investors who bought it with a ½ percent yield have lost 9% of its current market value. 

With interest rates rising over the next several years as a result of stronger economic growth, higher inflation and Fed tapering, existing bond holdings will decline in price and overall return. The diversion from bonds to equities in a 70/30 versus a 60/40 portfolio will help returns, albeit with higher volatility. How the 30% bond allocation is managed also will affect portfolio returns. Shorter-duration fixed income, including increasing cash balances, and alternative investments can mitigate the drag of rising interest rates driving bond prices lower.

Income yield on stocks, investment-grade bonds and 10-year Treasury securities are all the same 1.5%, so the opportunity cost of lower dividend or income is zero. The risk profile of each is more different in the shorter term, but less so over time, and thus more favorable to higher stock allocations than to bonds — especially with bonds having ended their 40-year bull market with interest rates falling from double digits to near zero.

Volatility of both stocks and bonds tends to normalize over time. This means that in any one year, historical upside and downside can be significant, but for five-year rolling periods, the range is compressed and the downside difference between stocks and bonds is small:

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For younger investors — and those with alternative sources of income covering essential spending — being able to wait for markets to correct supports the higher allocation to risk assets. For older investors, the accumulated benefits of above-average equity risk returns over the past 12 years provide a similar comfort margin. 

To summarize, 70/30 looks like the new 60/40, at least until stock and bond markets find a different path.

Steven L. Skancke is chief economic adviser at Keel Point.