Why 60/40

  By Guest Blogger Ryan Lewenza

All it took was a bit of volatility and a 10% market correction to wake investors up from their low volatility induced stupor. Well a “bit of volatility” is maybe downplaying what we’ve witnessed in recent weeks with the VIX or “fear index” rocketing higher from a near historical low of 9 in early January to a peak of 37 in early February. And with the spike in volatility and market correction, out come the doom and gloomers once again peddling their fear based prognostications of an imminent bear market and further market carnage. Not surprisingly we’re fielding some queries from clients on whether our recommended asset mix of 60% in equities and 40% in fixed income is still appropriate in light of this increased volatility. The short answer is yes, and in this week’s post we examine some of the inputs and analysis that goes into our preferred 60/40 asset mix.

Let’s start with a review of bear markets to see how the 60/40 portfolio performed versus the TSX and other portfolio models. Using the S&P/TSX Total Return Index and the FTSE TMX Canada Universe Bond Index we analyzed portfolio returns in the four last major bear markets of 2007, 2000, 1990 and 1980.

On average the 60/40 portfolio declined 20% peak-to-trough in the last four bear markets, roughly half of the 38% average decline in the TSX. A 50/50 and 40/60 portfolio declined 15% and 10%, respectively.

So of course even with a balanced or conservative portfolio they will decline during bear markets, but as you can see the declines are far less severe than an all equity investor.
Now you may be wondering why not just move from a 60/40 to a 40/60 portfolio ahead of the bear market to reduce the potential downside. While we may tweak the 60/40 asset mix if we believe a bear market is coming, we generally will stick with the 60/40 asset mix since we recognize how difficult is to perfectly time the markets as it requires you to get both the sell and buy just right. For this reason we recommend investors stick with their long-term or strategic asset mix over time.

Performance during Bear Markets

Source: Bloomberg, Turner Investments

Below we show the last two bear markets of 2007 and 2000 to better illustrate how these different portfolios hold up much better than the overall TSX.

Performance for the 2007 and 2000 Bear Markets

Source: Bloomberg, Turner Investments

The second thing I looked at was how long it took to get back to even following a bear market. In the table below I show that on average it took the TSX 24 months to get back to even following the bottom of the bear market, versus 10.5 months for our preferred 60/40 portfolio. For the 50/50 and 40/60 portfolios they were back at even quicker at 9 and 6 months, respectively, since they declined far less during the bear market.

This is another factor supporting our preference for a 60/40 balanced portfolio

Number of Months to Get Back to Even

Source: Bloomberg, Turner Investments

Finally, I looked at historical returns with the analysis in the table below. Since 1980, the TSX has returned on average 10.2% annually, just above the 60/40 at 9.8%. However, this was during a time of record high interest rates, which then consistently declined helping to deliver nice capital gains for bonds. Well, those days are long gone and we see much lower rates of returns from bonds over the next decade.

I believe returns will be more consistent with what we’ve witnessed since 2000, with the 60/40 portfolio delivering an average annual return of 6.9%. The 50/50 and 40/60 portfolios returned 6.7% and 6.6%, respectively over this period.

Given our expectations for lower bond yields over the next decade we see the 50/50 and 40/60 portfolios delivering lower returns going forward of potentially 6.4% and 5.8%, respectively.

Historical and Future Portfolio Returns

Source: Bloomberg, Turner Investments

Wow, that’s a lot of data and analysis to take in. Here are the key takeaways:

• The 60/40 portfolio declines far less than the TSX in bear markets which better helps investors control their emotions and stay committed to their long-term financial plan
• The 60/40 model gets back to even far faster than the TSX but not as quick as the 50/50 and 40/60 models
• The 60/40 portfolio has and should continue to deliver long-term returns of 6.9%, which is better than the 50/50 and 40/60 models but should return less than the TSX over the long-run

Put it all together, readers and clients, stick with the 60/40 asset mix for now and over the long-run!

Ryan Lewenza, CFA,CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.