Does a 60/40 Balanced Portfolio Still Work? Time to Jettison Non-U.S. Stocks?
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Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I'm your host, David Stein. Today's episode 420. It's titled, Does a 60-40 Balanced Portfolio Still Work? Back in the 90s when I first became an institutional investment advisor,

We talked a lot with clients about 60-40 portfolios, 50-50, 70-30. When we talk about a 60-40 portfolio, we're talking about a portfolio, a balanced portfolio that has 60% in stocks, 40% in bonds. And that was sort of a standard portfolio back in the 1990s.

As we work with clients, we might introduce non-US stocks to them, small cap stocks to them, but they were fairly simple portfolios.

diversified in terms of the number of holdings. Oftentimes, we might use index funds partnered with some active strategies. But then as we got into the 2000s, we started introducing additional asset classes to our clients. It could be public real estate investment trust, non-investment grade bonds, private strategies such as leveraged buyout funds, private real estate, even some hedge funds.

These additional complications may or may not necessarily have been better, particularly if as investors we don't understand what we're investing in. At the beginning of this year, I saw numerous articles in the financial press regarding 60-40 portfolios, such as in the Wall Street Journal, a

A piece titled BlackRock vs. Goldman in the Fight Over 60-40. Another in the Financial Times. Battered 60-40 portfolios face another challenging year. I'll admit I don't spend a lot of time thinking in terms of 60-40 portfolios or 50-50 portfolios. We do have some static model portfolio examples, some money for the rest of us plus, that are 60-40 or 70-30. But

But generally speaking, my portfolio, for example, I don't consider a 60-40 because I have numerous other asset classes. The adaptive model portfolios that we have have some additional asset classes, but it is a straightforward way to structure a portfolio. And it's been incredibly successful.

Except it wasn't last year. According to BlackRock, the typical 60-40 portfolio lost 17% in 2022. That was the worst performance since 2008. And depending on the mix, the type of stocks, it could have been the worst since 1980. Sharman Masavaramani said,

whose head of investment strategy at Goldman Sachs said, it happened, losses on both stocks and bonds. He says, it's happened in the past. It will happen in the future, but it's rare. Last year, bonds lost over 10% and stocks, in many cases, lost over 20%. Goldman Sachs calculated that a balanced portfolio of U.S. stocks and bonds lost

lost money over a 12-month period just 2% of the time going back to 1926, losses on both stocks and bonds. If we go back to 1980 and look at a balanced portfolio, a 60-40 portfolio made up of global stocks and global bonds, it's only had six negative year returns, calendar years, since 1980. Most of the years, it's been positive.

with the average 60-40 portfolio returning 6-7% between 1999 and 2022. The question is, what index are we measuring? And as I went through the different articles and found a slew of articles, even back in 2020, questioning this.

or defending the 60-40 portfolio, and I'll link to those articles in the show notes. But one standard and one study is the stock portion could be made up of the MSCI All-Country World Index. A Vanguard ETF that approximates that would be the Vanguard Total World Stock Index Fund ETF.

Some of the studies looked for the bonds. They used 40% the Bloomberg Barclays Global Aggregate Index on a hedged basis so it would protect any fluctuations in U.S. dollars. And the equity component is typically unhedged. And so a strengthening dollar in that case would hurt overseas returns.

Now, there are balanced portfolios made up of the S&P 500 index, 60%, just U.S. stocks, and the Bloomberg Barclays U.S. Aggregate Index, just U.S. bonds, and BND, the Vanguard Total Bond Market Index Fund ETF, would be an approximation of the U.S. aggregate. So there's different ways to structure these portfolios, but why do it?

James McIntosh, writing in the Wall Street Journal, wrote, Plus, it's easy, he writes.

So we get the growth component, we get the dividends from stocks plus the growth of those dividends over time as earnings grow, and we get income and stability from the bonds. We get diversification. McIntosh continues, the best argument for sticking with 60-40 at least as a base is that it's a decent neutral portfolio when we don't have any idea about how the future will work out. Bonds have sometimes lost money at the same time as stocks for extended periods in the past, but not often.

There's a diversification benefit of having stocks and bonds in a portfolio. If we look at the daily returns of stocks and bonds and look at them over a series of one-year periods, whether their prices move in tandem or they move counter to each other, since 2001, bond prices and stock prices have been negatively correlated.

That means that as stock prices have risen, bond prices have fallen because their yields have typically risen.

which means as the stocks have fallen, we often see the bond prices increase because the yields on bonds fell just like the stocks did. But it hasn't always been that way. From 1984 to 1998, bond prices and stock prices were mostly positively correlated. Stock prices were increasing and bond prices were increasing also as interest

interest rates and bond yields fell. Now, it was actually a great time to be invested in even in a balanced portfolio then because bonds were doing incredibly well and stocks were doing incredibly well as interest rates fell. But generally, there's a correlation benefit, particularly when stocks sell off, bond prices have generally appreciated, but not last year. Last year, interest rates increased significantly, bonds lost over 10%,

And that upward pressure on interest rates plus inflation pushed down the price of stocks and the value of stocks.

Another proponent for a 60-40 type balanced portfolio is John Bilton. He's head of global multi-asset strategy at J.P. Morgan Asset Management. Last December, he wrote, Investors can view the past year's volatility as bringing market pricing back to par. The reversal of cyclical elements of asset returns, like starting yields and valuations, swung from headwinds to tailwinds.

What does he mean? When we model out expected returns, and we do this on Money for the Rest of Us Plus, and certainly we discuss it in the podcast, we look at starting conditions. What are the starting yields for bonds? As we talked about in our bond masterclass a few episodes ago, that starting yield on bonds is an excellent predictor of what the

the total return will be over a 7 to 10 year holding period. Now, with interest rates higher, that means the expected return for investing in bonds is now higher.

We've also seen the valuations for stocks get lower. They're cheaper, which means the expected returns for stocks is now higher than it was a year ago. John Bilton of J.P. Morgan Asset Management continues, our annual long-term capital market assumptions forecast returns for a dollar-denominated 60-40 stock bond portfolio over the next 10 years leaps from 4.3%

last year to 7.2%. That's their highest projected return for a 60-40 portfolio since 2010. And it's above the 10-year rolling annualized average return that a 60-40 portfolio has returned based on their calculations of 6.1%.

On Monday for the rest of us plus, we have a static 60-40 portfolio made up of the Vanguard Total World Stock Market ETF and then 40% in the Vanguard Total Bond Market ETF. The expected return of that portfolio now is 6.3% with a probable range of 3.4%.

and 7.5%. A year ago, January 2022, the expected return of that 60-40 mix using those two Vanguard ETFs was 4.2% expected return with a range of 1.4% and 6%. And so the expected return is two percentage points higher today than a year ago because bonds

bond yields are higher and stock valuations are lower. And a 60-40 portfolio is a simple portfolio. It's straightforward. It's returned 6% to 7% annualized. And it is incredibly rare for both bonds and stocks to lose at the same time. Now, there are those that are against 60-40 portfolios. Why would they be opposed?

The primary reason I saw was because those analysts felt that the returns were not high enough for the investor to meet their target. Vincent Dillard, a global macro strategist at StoneX Group, backtracked.

back in 2020 predicted a nuclear winter for a 60-40 portfolio. He said it's hard to see where your equity returns come from, and low bond yields will not help offset a poor performance from the share market. It's just math. He's looking at the starting conditions back in 2020 and suggesting some individuals and institutions, they expect returns too low, so they're going to have to move into other sectors

higher performing asset classes. He said long-term asset allocators will need to find a replacement strategy if they are to meet their target returns. David Kelly, chief global strategist at JP Morgan Funds, said back in 2020, the standard 60-40 portfolio is not very well suited for today's financial market environment. Investors require a multicolored pie that shifts away from U.S. bonds and

in large cap stocks, and he suggested adding additional asset classes such as foreign equities, value stocks, and emerging market stocks.

Vivek Paul, head of portfolio research at BlackRock Research Institute, said, we're not anticipating performance in 2023 will be as bad as 2022. But the broader point is you can do better than 60-40 with a similar risk profile. These analysts are not saying 60-40 is bad. A straight up 60% stocks, 40% bonds. It's a very workable portfolio. It's simple and

And it has performed well over the long term. What they're saying is as an investor does their asset allocation and figures out what their return will be. And you see this most often with an endowment or a foundation that has a certain spending policy. And with those low bond yields and low expected return for stocks like we've had this last several years, they have moved more into private assets.

assets, venture capital, private real estate, in some cases, commodities. As individual investors, we don't always have that opportunity, nor do we necessarily want to. Now, we've talked about some. We've talked about real estate on this show. We've talked about art. But the fees tend to be higher as individual investors. Many of us don't want to spend time researching those private assets. It takes more work to invest outside of a plain vanilla 60-40 portfolio.

Now, there are simpler asset classes that can be added. I recently, in my portfolio, increased my allocation to preferred stocks. And we shared in one of our Plus episodes a discussion on why I made that particular trade. One of the other challenges of private assets is they mask volatility.

Because many of those assets are appraisal-based, take art, for example. Masterworks has been a longtime sponsor of the podcast. I've invested through Masterworks. But if you see the value of the art that I have in Masterworks, it doesn't change from day to day or month to month. They do an appraisal once a year, and it can adjust the value based on that. We've discussed a few episodes ago when we were talking about private REITs.

that private real estate investment trust. Those net asset values are based on appraisals. And so if appraisals for commercial real estate start to fall, then that will lead to lower net asset values. And then you would see a lower return for these private assets. In other words, there could be a lag. And because they're not valuing them as frequently, they look less volatile. When we used to do asset allocations, basically,

based on modern portfolio theory at my prior firm, where you needed a volatility assumption, we would imply one. Like what would be the volatility of private equity if it was traded daily? That's kind of how those models that use MPT work. On Money for the Restless Plus, we don't use volatility.

volatility as our measure of risk, we use the maximum drawdown. How much could you lose in this particular asset to help gauge the risk of portfolios? Before we continue, let me pause and share some words from this week's sponsors.

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Back to Vivek Paul, head of portfolio research at BlackRock. He mentioned that BlackRock is suggesting their clients underweight private markets currently and that institutional clients should have 20% in private assets

or it was 20%. Now it's 15 to 17%. He continues, however, we think private markets should be a larger allocation than what we see most investors hold today. And in this case, he's talking about individual investors. I personally have closer to 20% in private capital assets, but I've done it through some of the funds available through my prior firm. And I recognize, and it's sort of one of the frustrations as individual investors that want to invest in private

private equity, private real estate. It's just not always easy to do. Although, as I mentioned, there are more platforms such as Fundrise, which is also a sponsor of the show. In deciding then on a 60-40 portfolio, based on those that are saying don't do it or it's not as good, it comes down to what expected return would you like? As I mentioned, a 60-40 portfolio right now, based on our expected returns over the next 20 years, has a

an expected nominal return of 6.3% annualized. And you can plug that into some type of retirement calculator. We have those on the plus site also, so you can see what your value of your portfolio would be if it returned 6.3% per year based on how much you're saving each year. And then an investor can decide, is that nest egg large enough?

If an investor wants to add additional asset classes to their core 60-40 portfolio or their core 70-30 portfolio, that certainly is an option. And then you can spend time learning about those, make sure you understand them before you invest, and then complement the traditional 60-40 type portfolio. That brings up the question, though, what about U.S. versus non-U.S.?

If your 60-40 portfolio was invested in the S&P 500 last year, let's say the Vanguard S&P 500 index fund versus the Vanguard Total World Stock Market ETF, VT, the balanced portfolio invested in U.S. stocks would have done much, much better over the past decades.

One of the software tools that we've been developing and will hopefully roll out here in the next month or so is the ability to look at the returns of different stock indices around the world and deconstruct what were the drivers of the returns. If we look at U.S. stocks, for example, they've returned 12% annualized over the last year.

over the past decade. If we break those downs into the components that contributed to the returns, 1.9% was dividend yields, 7.2% was earnings growth, and 3.1%

was from the valuation change. U.S. stocks got more expensive over the past decade. A decade ago, the P.E. of U.S. stocks was 15.3. Now it's 20.8, and that added 3.1% per year in contribution to the return. In other words,

If the return had just been the dividend yield plus the earnings growth, the return would have been 9.1%. Now let's compare that to the world ex-US. So this is developed markets, not counting the US. Over the past decade, the return was much lower, 4.9% annualized.

Who wouldn't want to have had the 12% for U.S. stocks versus 4.9% for non-U.S. developed stocks? But we need to look at what were the drivers. 3.1% of that 4.9% return was due to the dividend yield. Earnings grew at 5.8% for non-U.S. stocks, so earnings didn't grow as fast. In U.S., earnings grew 7.2% over the past decade. Part of that was due to the one-time tax cut and

and lower corporate tax rates for corporations which boosted

their earnings growth, as well as buybacks, more buybacks for U.S. companies. But the reality is their earnings grew faster, 7.2% per year versus 5.8% for non-U.S. stocks. But if we add the dividend yield, it's higher outside the U.S. So it's 3.1% dividend yield contribution plus 5.8% earnings growth. That gets us to an 8.9% return just for those two components versus 9.1% for U.S. stocks.

But there were some performance drags for non-U.S. stocks. Valuations got cheaper and detracted about 0.9% per year from that return because the P.E. of non-U.S. stocks went from 15.8 10 years ago to 14.4. The other big detractor was currency. The U.S. dollar appreciated 25%.

against other world currencies, a basket of world currencies. This is U.S. dollar index. From 10 years ago, beginning of 2013 to the end of January 2023, we've seen a 25% appreciation in the dollar. That led to a 2.7% annual portfolio drag for non-U.S. stocks.

So that 3.1% dividend yield plus the 5.8% earnings growth, a 0.9% reduction due to the valuation changes, non-U.S. stocks getting cheaper, and currencies weakening relative to the U.S. dollar, that was another 2.7% drag, and that's why the return was 4.9%.

The question is, as we go forward, will that change? Could we get a tailwind from a weakening U.S. dollar? If the dollar just weakened from 114, this is the U.S. dollar index, down to 105, that would add 80 basis points per year in return over the next decade.

Now, emerging market stocks, they've struggled, and it wasn't just currency there. In their case, the dividend yield was 2.6% over the past decade. Their earnings growth was only 2.6%. So together, that was a 5.2% return, and there was no valuation change that contributed to the 10-year return. A decade ago, the P.E. of emerging markets was 12.8%, and today it's 12.8%.

But emerging market currencies also weakened relative to the U.S. dollar, and that had a negative 3% per year drag on performance. So the overall return of emerging markets, as quoted in U.S. dollars, was 2.1% annualized over the past decade.

Why did earnings grow so much slower in emerging markets? Their economies grow faster than developed markets, yet their earnings are growing slower. And there are two really big contributors. One is many emerging markets are companies are commodities focused. They're involved in mining.

And we have been in a bear market for commodities for most of the past decade. Now, commodities have picked up in the past year or so, and that's helped emerging market stocks and helped emerging market earnings. But over the past decade, if you look at the return of commodity indices, they're still negative. And that has impacted emerging market returns, as well as China's zero COVID policy in the

In the past year, China's earnings, which China makes up roughly 40% of emerging markets, their earnings have fallen 23% over the past year. So that's history. Emerging markets, non-U.S. developed markets, have lagged U.S. markets, U.S. stock market, over the past decade.

What we care about is going forward. What's a reasonable assumption? Our assumptions for emerging markets over the next decade is 8.5%. That includes 3.4% for the dividend yield, 4% nominal earnings growth, and a 1.1% valuation adjustment as we assume the P.E. will go from 12.2% up to 15.1%. Now that's our base case. We also have ranges of returns.

We believe U.S. stocks will return 7.2% over the next decade, with 1.7% dividend yield, 5.5% earnings growth, and no valuation change. And we believe that non-U.S. stocks, excluding emerging markets,

will return 7.3% over the next decade, with 3.3% coming from the dividend yield, 3.1% from earnings growth, and a 0.9% valuation adjustment. Now, these are the base cases. Earnings could come in higher than that. We're not assuming any type of currency adjustment. We effectively believe currency will be neutral because we don't have a way of forecasting whether over a decade the dollar will strengthen or weaken. Right now, it's

above, slightly above its long-term average over the past few decades. But if the dollar weakens substantially, that would be a big tailwind for non-U.S. stocks.

What I'm trying to say is we can't just say U.S. outperformed non-U.S. I'm going to sell all my non-U.S. stocks and put it in U.S. stocks because I believe non-U.S. will underperform like it has. Well, we can do that. We can say that, but we at least need to come up with some assumptions. We know that the dividend yield for non-U.S. stocks are higher.

If we believe that U.S. earnings will substantially grow faster than non-U.S., then that would be an argument to put more in U.S. And if we don't think valuations will be a positive contribution, we think valuations will stay the same, we think currency will stay the same.

Then in that case, maybe you do invest in the U.S. But we need a reasonable basis to understand those underlying return assumptions. And that's one of the reasons we're creating these tools so that investors can better understand what drove returns and then be able to model out future returns based on different assumptions for the dividend yield, the earnings growth, and the valuation chains to be able to model it out in real time to look at the different assumptions.

One of the discussions we've had on our plus member forum is just the impact of withholding taxes on non-U.S. dividend paying companies. And that can impact returns. We won't get into that there, but that's another thing we need to recognize. Let's circle back, though, and conclude. Does balanced portfolio still work? A 60-40 portfolio, a 70-30? Yes, absolutely.

One bad year is not reason to throw out a successful strategy. Now we can model out different weights and we need to figure out what the expected return is of any portfolio. A 60-40 portfolio of global stocks and bonds can be the core.

we can complement it with additional strategies. It could be a value tilt. It could be a regional tilt. We could add additional public and private asset classes. We can have some flexibility. If we're close to retirement or in retirement, we probably want some guaranteed source of income, be it an annuity or a pension, so we're not completely dependent on our investment portfolio for our returns.

But I don't think balanced portfolios are dead. I think it's a reasonable approach. If you want to do it with two ETFs, it can be done. If you want to complement that with additional asset classes as you learn those asset classes, that's one of the things we do on Money for the Rest of Us. Teach asset class investing and understand what drives the return of asset classes and what is a reasonable assumption going forward. That's episode 420. Thanks for listening.

Everything I've shared with you in this episode has been for general education. I've not considered your specific risk situation. I've not provided investment advice. This is simply general education on money, investing in the economy. Have a great week.