Jonathan Schreiber, CFA, Senior Investment Director, & Chris Galipeau, Senior Market Strategist – Putnam Investments
March 15, 2023
With equity and fixed income markets under pressure last year, a rare market signal in September 2022 pointed to strong potential future returns for the traditional 60/40 portfolio.
A historical look at that signal led us to the conclusion that the traditional balanced portfolio delivered positive returns in 100% of observations and provided risk-adjusted returns that were superior to both stocks and bonds individually. Though markets have bounced off the September 2022 lows, we believe the potential remains for positive performance from these asset classes going forward, especially from the balanced portfolio.
Here’s what our research found:
The historical perspective
In studying the performance of the traditional 60/40 portfolio, we have nearly a century’s worth of data to consider. For this example, the 60/40 portfolio uses U.S. large cap stocks and a blend of intermediate-term and long-term Treasury bonds.*
So, how extreme was the loss sustained by 60/40 through Q3 2022? Looking at calendar year returns back to the mid-1920s, the 22.1% loss ranked second all-time. The losses experienced in the traditional balanced portfolio were greater in 2022 than in any year since 1931.
Figure 1
Sources: Bloomberg, Putnam. *U.S. large cap stocks: IA SBBI Large Stock TR USD before 31 January 1988 and S&P 500 TR thereafter; U.S. intermediate term treasuries: IA SBBI U.S. IT Govt TR USD before 31 January 1973 and Bloomberg U.S. Treasury Intermediate Index thereafter; U.S. long term treasuries: IA SBBI US LT Govt TR USD before 31 March 1992 and Bloomberg U.S. Treasury 20+ Index thereafter; 60/40 Portfolio: 60% U.S. large cap stocks, 20% U.S. intermediate term treasuries, 20% U.S. long term treasuries, rebalanced monthly.
1. Consider forward returns
With recent performance in context, we then look to understand how the traditional 60/40 portfolio has performed following similar periods. We found that there have been nine instances when both stocks and bonds were trading below their 36-month moving average. The observation, as of Sept. 30, 2022, marks the 10th. In this analysis, any month-end where both stocks and bonds are below their moving average serves as a signal.
As the chart below indicates, stocks, bonds, and 60/40 each average strong returns in the 12 months following a signal. Importantly, the average return is meaningfully higher than the return realized over the full history.
Figure 2
Sources: Bloomberg, Putnam
These figures are shown for illustrative purposes only and are not guaranteed. They do not reflect taxes or investment/product fees or expenses, which would reduce the figures shown here. Past performance is not a guarantee of future results.
2. Factor in hit rate and Sharpe ratio
With all three assets demonstrating outperformance following a signal, one could make the case that the higher average return for stocks is a reason to own equities and not 60/40. But averages can be skewed by outliers and, while nominal return is important, a prudent investor also values consistency and considers risk.
We make two additional observations about asset class returns when the signal described above is active.
- First, the 60/40 portfolio and bonds deliver positive forward one-year returns in all nine cases, delivering a 100% hit rate, which measures the percent of time returns ended positive. Stocks are positive in only seven. So, while stocks delivered a better average return, they still ended negative in 22% of the forward one-year periods. The 60/40 portfolio and bonds were always positive.
- Second, looking beyond just hit rates, we see that stocks underperformed bonds in another observation where both stocks and bonds finished positive. So not only is the stock hit rate lower, but even when stocks delivered positive returns they did not necessarily outperform the 60/40 portfolio and bonds (see Figure 3).
As a result, there is still a meaningful diversification benefit to owning 60/40 in volatile periods. When risk is high, investors want to receive maximum compensation for any risk they are taking.
The Sharpe ratio measures how much return an asset delivers relative to its risk. Not only are forward one-year returns significant following a signal, but as Figure 4 below illustrates, forward one-year risk-adjusted returns are also remarkably strong. In fact, the average forward Sharpe ratio of 60/40 is ahead of both stocks and bonds in our nine post-signal observations, demonstrating the power of diversification.
Figure 3
Figure 4
3. The qualitative case
While we believe a strong empirical case exists, we also recognize that informed judgment adds value to the investment decision. Volatility in both stock and bond markets remains high. The benefit of multi-asset portfolios is they are not dependent on a single outcome to deliver positive results. By combining stocks and bonds, the traditional 60/40 portfolio can offer investors a mix of upside potential while mitigating downside risk.
Bottom line
2022 delivered a challenging investment environment — for owners of stocks, bonds, or a balance of the two. The 60/40 portfolio has experienced losses not seen in over 90 years. But we believe there is reason for optimism. While unclear exactly what the future holds, history shows that now could be an attractive time to consider a traditional 60/40 portfolio again.