The balanced portfolio, consisting of 60 percent equities and 40 percent bonds, has been the mainstay of investors for decades, providing exposure to higher returns from equities and protecting the downside by a substantial allocation to low risk government bonds. After the 60/40 portfolio had its worst year ever in 2022 and equity/bond correlation has stayed high, investors need to look elsewhere for diversification. Crypto asset’s typically low correlation with other asset classes can help.
The 60/40 portfolio stopped working
In the past, the 60/40 portfolio provided reliable returns while mitigating the downside through exposure to government bonds.
The monthly returns for the 60/40 portfolio over the last 10 years show that negative equity returns were partly offset by positive bond returns in 35-40 percent of the months, and when bond returns were also negative, they were only very slightly so. The average S&P500 return of months with losses over the last 10 years was -3.8 percent, while the average US Treasury bond return was -0.2 percent for these months.
However, in 2022 US Treasuries had their worst year in recorded history (with data going back to 1754), and they are no longer a reliable “low risk” asset class. The US bond market suffered losses that were close to those of the equity market, and with the longest end of the treasury market, the 30-year bond lost almost -40 percent.1
What caused the 60/40 portfolio to fail?
Bonds failed to provide the downside protection they had offered historically as they have been undermined by the spiralling indebtedness of the US government and the extraordinary levels of inflationary money printing by the US Federal Reserve.
With high levels of debt across the economy, rate rises also had a greater impact on the equity market, and equity/bond correlation increased sharply.
1-year correlation: S&P500 and iShares US Treasury Bond ETF
Source: Standard & Poors, iShares
Is the outlook better for the 60/40 portfolio?
The increase in the US government’s indebtedness has only accelerated since. After last year’s “suspension” of the debt ceiling, the rate of increase has been even faster, with no apparent signs of stopping the rise in the budget deficit or capping government spending on unproductive uses. Similarly, there does not appear to be any political will to hold government agencies accountable for missing money. The Pentagon, for example, failed its sixth audit in a row last year, being unable to account for 63 percent of its USD 3.8 trillion in assets.
As a result, two of the three leading ratings agencies have already downgraded US government credit, and the third one changed its outlook to “negative”. The prospects appear poor for US government bonds to act as low risk buffers in a portfolio.
Meanwhile equity/bond correlation has remained historically high, and the risks to the equity markets have also increased. Although equities have performed well over the last 5 years, rising between 15-30 percent each year except in 2022, the risks have increased and include stretched valuations, high corporate leverage and a slowdown in the real economy. In addition, the performance of the S&P500 was highly concentrated in a small number of stocks last year (the “magnificent seven”) and appears even more concentrated this year, as only three stocks (Microsoft, Meta and Nvidia) have driven the market gains. The S&P500 Equal Weight Index has substantially underperformed the S&P500 over the past year, and while the S&P500 achieved new highs recently, most sectors within the index did not.
How can investors diversify their portfolio?
Unsurprisingly, investors have been increasingly turning to alternative asset classes for diversification, and it is worth considering crypto assets in this process.
Crypto correlation with other assets classes was anomalously high for a brief period in 2022; however, it has since reverted to its historic norms. After continuing to fall for most of the past year, it remains close to, or slightly below, 0 percent.
Crypto assets provide an interesting alternative for portfolio diversification due to their historically low correlation with other assets, coupled with increasing mainstream acceptance and a medium to long-term megatrend for the adoption of this new technology.
[1] Why the Classic Stock-and-Bond Investment Strategy Isn’t Working – WSJ
Read more about crypto assets from Sygnum here.
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