Is the 60:40 portfolio really dead?

To be sure, this portfolio’s gain last year was well above the average of the last 150 years. So it would be unrealistic to expect a repeat. And it is true that interest rates are low, creating stiff headwinds for the bond portion of the portfolio going forward. Should retirees continue to have faith in the 60:40 portfolio?

That question in effect boils down to whether retirees should have a healthy allocation to bonds, since no one has suggested that the stock portion be eliminated. And I think retirees should not be too quick to give up on bonds, for a variety of reasons.

Stock-bond correlations are low when rates are low

For starters, it’s helpful to stand back and review why retirees are urged to have a healthy bond allocation in the first place. One of the most important reasons is the low correlation between stocks and bonds, because of which bonds are likely to perform well when stocks are performing poorly (and vice versa). A 60% stock and 40% bond portfolio will therefore incur much lower volatility, or risk, that an all-stock portfolio.

This background is important because the stock-bond correlation tends to be lower when interest rates are low. Like now, in other words, as you can see in the accompanying chart. Far from suggesting that low rates are a reason to give up on the 60:40 portfolio, the historical data suggests that the portfolio is more useful than ever.

To be sure, stock-bond correlations aren’t always low. They likely would rise in coming years if inflation were to heat up, since that would most likely lead to the Fed tightening its monetary policy—which, in turn, would be negative for both stocks and bonds. AQR this week released its latest analysis of the stock-bond correlation, and it concluded that “on balance, given the continued strong anchoring of inflation expectations, the negative stock-bond correlation also seems likely to continue over the medium term, though episodes of higher correlation are also possible.”

Bonds aren’t necessarily a bad idea when rates are headed higher

Another reason not to give up on the 60:40 portfolio is that bonds don’t automatically lose money even when rates are rising.

I know this goes against everything you’ve been told about the relationship between rates and bond prices, so let me explain. The key is to own a bond ladder or bond fund with a fixed average duration. If you do, provided you hold on long enough, the return you earn with a bond portfolio will be very close to its initial yield—regardless of what happens to rates along the way.

Duration, of course, refers to a bond portfolio’s sensitivity to changes in interest rates. If it has an average duration of five years, for example, it would be expected to gain 5% for every 1% reduction in interest rates—and vice versa. According to research that was published in the December 2018 issue of the Journal of Portfolio Management, your bond portfolio’s return will be equal to its initial yield so long as you own it for one year less than twice its average duration. In my example of a portfolio with a five-year average duration, this would mean holding it for nine years.

The reason this formula works is that a bond fund or ladder with a fixed duration will reinvest any maturing bond in a new one with a sufficiently long maturity as to maintain the portfolio’s average duration. In a rising-rate environment, the higher yields of these newly-bought bonds will eventually make up for the loss incurred by previously-held bonds.

Diversification is a virtue

It’s also helpful to remember that the broader lesson here is that diversification is a virtue. The origins of the 60:40 portfolio trace back to a long-ago era in which stocks and bonds were the only two major asset classes. That is no longer the case, needless to say.

Research Affiliates this week proposed a more diversified basket than the 60:40 portfolio, divided three ways between equities (both domestic and foreign), bonds, and inflation hedges (assets such as the Treasury’s Inflation-Protected Bonds, or TIPS, commodities, and real-estate investment trusts). Including this third pillar would be especially welcome in the event, as mentioned above, inflation heats up and stock-bond correlations increase. Over the last 45 years this more diversified portfolio performed admirably, according to the firm’s calculations.

The bottom line? Don’t give up on the 60:40 portfolio, or on diversification generally.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [email protected].