>
It’s been a year to forget for the average investor, with the value of stocks and bonds in freefall for most of 2022.
More than £1.3 trillion has been wiped from the value of UK bonds since the start of the year amid a wider sell-off, while equity markets have plummeted at the same time.
While the FTSE 100 has outperformed its international peers in relative terms, it is down almost two percent since the start of the year, while the FTSE 250 is down 19 percent.
Investors may be tempted to adjust their portfolio allocation given the market sell-off, but Vanguard argues the 60/40 split is still effective
The traditional 60/40 portfolio – with 60 percent invested in equities and the remaining 40 percent in bonds – has suffered a dent as a result.
Historically, there has been a negative correlation between stocks and bonds, meaning investors in falling stock markets can usually find comfort in the bond market.
This year both stocks and bonds have suffered at the same time, leading many to wonder how appropriate the 60/40 allocation is now.
Could 2022 mark the end of this traditional asset allocation or is it just an outlier?
We speak to Vanguard’s Muheet Dhir and James Norton who say the demise of the 60/40 has been greatly exaggerated.
Is the 60/40 wallet really dead?
A perfect storm of market, economic and geopolitical conditions has made 2022 a difficult year for the markets.
For parts of the year, stocks and bonds have fallen simultaneously, something the 60/40 portfolio theoretically protects investors against.
Does this spell the death knell for this asset allocation split? Not quite, according to investment giant Vanguard.
It’s not the first time people have questioned the 60/40 portfolio. It happens again and again and it’s usually when bonds don’t do well, as clearly wasn’t the case this year,” said Muheet Dhir, multi-asset product specialist at Vanguard Europe.
“The positive correlation we saw between stocks and bonds really highlighted that [and] people started to worry about the performance of bonds in their portfolios. This led to the question ‘Do we still need bonds as a defensive element in the portfolio?’ because it didn’t go well this year.
“The reality is that historically there have been times when the short-term correlation tends to turn positive, usually when inflation is very high and there is also economic stress along with rising interest rates.”
For the most part, there was a negative correlation between bonds and stocks, meaning the 60/40 portfolio largely protected investors
Vanguard’s research shows that while asset classes can fall simultaneously for certain periods of time, this is usually short-lived and reverts to longer-term negative correlation.
Dhir adds: ‘If you look back at the average quarterly return on bonds, bonds have in most cases delivered a positive return.
“The numbers we saw for global bonds in Q1 and Q2 this year were a complete outlier when you look at average returns over the past 30 years.
“The short-term trend we’ve seen this year of positive correlation isn’t necessarily something we think will continue. We don’t think this is normal or a long-term average… We think it’s going to be negative correlation again if bonds really start playing their part.’
Vanguard expects the average return on a 60/40 portfolio to be about 5.5 percent in GBP over the next 30 years.
What are the prospects for 2023?
Bonds may historically be negatively correlated with stocks again, but investors are often reminded that past performance is no indication of future returns.
Vanguard emphasizes that the current behavior of bonds, while unusual, is not unprecedented.
So for things to be different this time around it would take a fundamental adjustment in the way the markets operate and they have seen little evidence of that.
The investment giant remains convinced that the bond market will soon act as a ballast for equities again and that the 60/40 portfolio will be justified.
The risk of a recession is very high. What that usually means is that there’s a flight to quality effect where investors convert stocks into bonds,” says Dhir. “In that scenario, we can really see bonds playing that role again and the correlations then turning negative… All the catalysts are there, it’s only a matter of time before it returns, as we’ve seen in the past. ‘
In a recession, even a mild one, central banks will be forced to step in and boost growth, meaning bond market performance is likely to improve, Vanguard said.
However, there are downside risks heading into 2023, not least if inflation does not fall as quickly as expected.
The Bank of England expects inflation to fall sharply from the middle of next year, largely thanks to the energy price guarantee.
Vanguard’s LifeStrategy 60, which holds 60% of its portfolio in equities, has held up since inception
Dhir says: ‘Of course there is always some uncertainty. Russia could go crazy in terms of what they plan to do and everything is out of our control again. Aside from that extreme scenario, I think growth and inflation are probably the two main risks we’re looking at.”
Investors can also take comfort from this year’s bond market correction as expected returns are now higher.
Vanguard’s expected 10-year bond yield was about 1.5 percent at the start of the year. It’s now closer to 4 to 5 percent.
James Norton, chief financial planners at Vanguard says, “While that will have lost 40 percent of the portfolio money, now is not the time to sell because they have a better chance of making up for those losses.
“In fact, for the first time in more than a decade, investors are getting a reasonable return on their bonds, which they haven’t since interest rates collapsed after the global financial crisis.”
What should investors do?
A 60/40 portfolio will not suit everyone. It assumes a certain kind of risk that an investor is comfortable with, but has proven largely effective, according to Vanguard.
It’s tempting to look at the performance of your portfolio this year, especially how bonds have suffered, and adjust your allocation. But this is the worst thing you can do, Norton warns.
“When you think back to the basics of why you invest, you know what your goal is… A 60/40 portfolio is right for someone who wants that risk. Now they want that level of risk because they’ve been thinking about it with a specific goal in mind, at a specific time.
It’s always tempting to do something [to your portfolio]. I’m tempted myself! But I’ve learned I don’t have a crystal ball… I know I can’t outsmart the markets but it’s really tempting to do it… Portfolios fall in value doesn’t mean they’re broken . Falling values are actually part of investing.’
One thing investors should pay attention to is the quality of not only the stocks in their portfolio, but also the bonds. Anything below triple B is more vulnerable to default risk.
Norton says, “We are very conscious about the types of bonds we hold. They are investment grade bonds, high quality. They are globally diversified… As soon as you deviate from those kinds of bonds, you take more risk again.’
Dhir adds that investors should consider diversifying their exposure within bonds themselves.
Don’t invest just part of the yield curve or maturity profile – ie. only have two to five year bonds, but are actually diversifying along the curve just because we think there is still some uncertainty and volatility in the market.”
Some links in this article may be affiliate links. If you click on it, we may earn a small commission. That helps us fund This Is Money and use it for free. We do not write articles to promote products. We do not allow any commercial relationship to compromise our editorial independence.