Investing Strategy - November 10, 2024

The 60/40 Portfolio: Why the Classic Model Faces Challenges, and How to Go Beyond

November 10, 2024

Soren Godbersen
By Soren Godbersen

Intro — What Is the 60/40 portfolio?

A 60/40 portfolio is a simple, classic asset allocation model that seeks to balance upside and safety and provide a degree of asset non-correlation. For most “mainstreet” investors this will mean 60% to a broad range of stocks — typically index funds or ETFs — and 40% to bonds (typically 10-year treasury bonds or other mainstream investment-grade bonds). The 60/40 portfolio has yielded stable returns during most periods in U.S. financial history and, up until 2020, recent performance has been particularly strong: in the decade before the COVID-19 crisis, a simple U.S. 60/40 portfolio delivered three-times its long-run average for risk-adjusted returns. The 60/40 portfolio has delivered more mixed results since the start of the pandemic, and may be in store for further volatility, as we will discuss.

Note that the 60/40 portfolio is a shorthand term for a basic stocks/bonds allocation. Most financial advisors will preach some version of the “100 minus your age” rule for allocating between stocks and bonds, and shifting this allocation over time. Younger investors, who have more years to absorb the ups and downs of the market, and who may enjoy an outsized benefit from near-term upside, often begin with closer to a 90/10 allocation between stocks and bonds. Investors closer to retirement may approach an inversion of this ratio, with closer to 90% of their public market allocation in bonds. This allocation also depends on the risk tolerance of the investor. That said, a 60/40 portfolio allocation is the ballpark standard public market allocation for many investors during much of their investing career.

60/40 Portfolio Definition

A 60/40 portfolio is an asset allocation strategy that puts 60% of the portfolio toward stocks and 40% toward bonds. Such a portfolio is typically rebalanced over time. The fundamental strategy is that public bond market and public stock market performance have had low or negative correlation for most periods in U.S. history. Bonds can therefore act as a counterweight to stocks during periods of stock market volatility. As recent experience shows, this relationship does not always hold true.

After a devastating 2022, the 60/40 portfolio has had a solid couple of years. The Fed at last began cutting interest rates in September of 2024, buoying the stock market. The results of the November 2024 presidential election portend lower corporate taxes and a deregulatory policy environment, both factors that could create ongoing stock market euphoria. Still, there are plenty of reasons to anticipate public market volatility in the near term, specifically:

  • High price/earnings ratios among publicly traded companies.
  • Positive stock market performance highly of concentrated to a handful of tech stocks, banking heavily on future AI innovation
  • Geopolitical risk, including ongoing foreign conflicts and energy cost volatility

Heightened volatility once again drives home the potential benefit of diversification to illiquid alternatives like private real estate. But what does the future hold for time-honored strategies like the 60/40 portfolio? Marc Rowan, CEO of Apollo, offers some words of caution. 

 

Why would we think the investment strategies of the last 40 years would work going forward? … I think to escape indexation and concentration, we’re going to turn to private markets.

— Marc Rowan, Apollo

Perspective on Market Volatility and the 60/40 Portfolio

In most down cycles, bonds provide a counterweight against stocks. This is due to the typically inverse relationship between bonds and interest rates. If the Federal Reserve Bank lowers interest rates to stimulate the economy, bond yields typically stand to gain. In other words, economic headwinds are usually bad for stocks and may benefit bonds. 

This diversification dynamic has been challenged by present market conditions. Stocks and bonds tend to bear a low or negative correlation during low inflation periods. In 2022, inflation and rising interest rates turned this relationship on its head and the 60/40 portfolio had its worst year since at least 1937.

Per Blackstone, the historical stock-bond correlation is just 14% during periods of 2-4% annualized inflation. Above 4%, however, the correlation climbed to 32%, undermining some of the hypothetical “counterweight” benefit of the classic 60/40 model. 

As Christian Muller-Glissman — head of asset allocation research at Goldman Sachs — put it recently, “In an environment where you have both growth risk and inflation risks, like stagflation, 60/40 portfolios are vulnerable and to some extent incomplete. You want to diversify more broadly to asset classes that can do better in that environment.”

In an investor webinar in late 2022, EquityMultiple Director of Capital Markets Charles DeAndrade explains the theory behind challenges to the 60/40 portfolio and how alternative assets can help provide a more “future proof” asset allocation strategy.

Going Beyond the 60/40 Portfolio

To recap: 60/40 portfolios rely partly on the negative relationship between bond yields and stock performance. This has held true through most phases of the business cycle through much of U.S. financial history, but it is not failsafe. In the period since mid-2022, market conditions have severely challenged the 60/40 portfolio for well-understood reasons.

In mid 2022, the economy entered a “quasi-stagflationary” period. The Fed has been spurred into action, raising interest rates several times to combat the persistent inflation that followed the monetary stimulus and supply chain issues caused by COVID-19. At the same time, a combination of rising rates, geopolitical volatility, and high energy costs have caused an economic slowdown and contributed to a stock market selloff. The S&P 500 lost nearly 20% of its value in the first half of the year, with many major tech stocks trading at below pre-pandemic levels. 

Per KKR, a 40/30/30 portfolio — with 30% devoted to private-market alternative assets — outperformed the stock market in all periods studied, but particularly during periods of high inflation, where the more diversified portfolio outperformed by over 4x on a risk-adjusted return basis.

With recessionary fears, rising rates, and lower economic growth forecasted, the expectation now is that forward returns on public equities will be lower than in recent years. At the same time, history tells us that rising interest rates are likely to adversely impact bond yields. In other words, in this “quasi-stagflationary” environment, we expect to see the correlation between stocks and bonds strengthen, and for bonds to provide less of a counterweight against poor stock market performance. At the same time, the return potential of both these major asset classes may be challenged. Forward-looking investors may be wise to seek alternative sources of yield, alternative sources of appreciation, and new ways to diversify their
portfolios. 

While the stock market has rebounded in 2023, the majority of gains have come from just 7 mega-cap tech stocks. This creates potential for future volatility.

 

 

 

Diversification is the only free lunch in finance.

– Harry Markowitz

How Real Estate Can Supplement the 60/40 Portfolio

REITs, in part due to their fairly strong correlation to public market investments, tend to perform poorly during recessions. However, illiquid alternatives — and particularly private commercial real estate — can provide near-term yield, long-term appreciation, and a higher degree of non-public asset correlation. 

Private real estate investment performance is comprised of three interrelated components:

  • Recurring cash flows from rents
  • Property value appreciation
  • Skilled management (capital structuring, business plan execution, and exit timing)

Let’s break down these three components in the context of market conditions in 2022 

Cash flow from rents (yield)

Rents can provide stable income to real estate investors as long as leasing activity remains strong and vacancy rates remain low. For illiquid, non-traded real estate assets (discrete properties) the cash flow from rents depends on rental demand in the individual market, as opposed to yields from bonds or dividend stocks, which may fluctuate due to sentiment in the public markets. Property managers can structure leases to capture overall price increases, which is the primary reason that real estate tends to perform relatively well during inflationary periods in terms of real returns. According to an analysis by the Pension Real Estate Association (PREA) based on data spanning 1979-2021, net operating income across various real estate sectors increased 0.50% for every 1.00% in inflation increase, with shorter-leased sectors such as residential even more responsive at ~0.80%. 

While news headlines may be focused on recession fears, many economic fundamentals remain strong, including job growth. Multifamily in particular tends to perform well during both recessions and inflationary periods due to the essential nature of the product and relatively short leases. 

At this moment, cash-flowing real estate may provide a great supplement to the traditional 60/40 portfolio as a diversified source of yield. 

Property value appreciation (upside)

Property values move predictably as multiples of rental cashflow and as a function of supply versus demand of similar properties in the market. Market conditions as of late 2023 may favor many types of commercial real estate assets. Let’s look at both components:

  • Rents tend to move upward predictably alongside overall inflation. In fact, average rents (especially in the apartment sector) are part and parcel of inflation. Apartment rents in the US rose at the fastest pace in June 2022 of any month since 1986. As rents increase, property values rapidly respond in kind. Hence, the long-term appreciation of real estate assets may be naturally hedged against inflation. According to research by PGIM, global real estate has provided a virtually perfect hedge against inflation, with all property real rental growth (vs. unadjusted nominal rental growth) at precisely zero in the past 40 years. Moreover, research by PREA based on data spanning 1979-2021 indicates that real estate can capture inflation in property values, with residential properties appreciating by ~1.1% for every 1% increase in inflation.
  • Supply vs. demand — job growth remains strong, and despite plenty of talk of a recession, the economy remains fundamentally stable. Rising interest rates may cool off the single-family housing market, further contributing to demand in the apartment rental market. Generally, demand remains strong across most real estate asset classes in most markets (though office may face challenges due to the increased adoption of remote work). At the same time, increased cost of capital and high construction costs may suppress supply, creating opportunity for real estate developers and sponsors who can leverage a competitive advantage in financing and/or executing on their business plan. Although impactful, a rising interest rate does not have to be catastrophic for commercial real estate values – PGIM research indicates that the impact to valuation by a 1.0% increase in bond yields can be offset by a consistent 0.50% increase in rental growth. 

For both these reasons, private real estate investments may currently provide an attractive alternative to the traditional stock portfolio in terms of generating appreciation and upside potential.

Total Return, First Half of 2022

How EquityMultiple Investments Can Supplement a 60/40 Portfolio

Market conditions as of mid-2022 challenge the appreciation potential of a traditional stock portfolio, the yield potential of bonds, and the classic diversification thesis of the traditional 60/40 portfolio. Specific types of EquityMultiple investments may provide an excellent substitute or complement to the traditional 60/40 portfolio to mitigate all three challenges:

Short-term notes, which target a 5-6% annualized yield over a six or nine-month term, can provide an alternative source of yield at a time when real returns from savings accounts may be challenged by inflation. 

Many institutional investors have taken the stance of allocating more to cash as volatility increased throughout 2022 and early 2023. However, cash may no longer be king if interest rates broadly decline. In December, 2023, the Fed indicated likely rate cuts throughout 2024. EquityMultiple’s Alpine Notes provide an attractive alternative to cash, with APY’s (as of January, 2024) as high as 7.4%.

Debt and preferred equity offerings may provide a source of near-term, predictable yield (typically monthly or quarterly distributions and target annual returns in the 8-12% range) to help offset challenges facing income stocks and bond yields. With terms ranging from nine months to three years, these types of investments can also help investors ladder maturities and benefit from relatively attractive liquidity (versus other illiquid assets). EquityMultiple’s preferred equity investments, in particular, often give investors the potential to earn additional accrued preferred returns at the end of the investment’s term. Hence, these investments may provide a compounding benefit and flexibility at a time when the impact of inflation could be more damaging to lower-return fixed-rate investments. 

As of mid-2023, EquityMultiple has doubled down on private real estate debt investments. We consider this moment an enormous opportunity for debt investment, due to tight credit in real estate capital markets and elevated rates. The Ascent Income Fund gives individual investors a diversified, streamlined entry point to this type of opportunity.

Common equity offerings on EquityMultiple may provide a great alternative to and non-correlated diversification against stocks, and a potentially superior risk-adjusted return profile, which investors typically rely on for long-term appreciation. 

For a comprehensive look at EquityMultiple’s offering types in the asset class landscape, please refer to this guide

Taking a broader look at historical data: in analysis from JP Morgan, observed asset returns from the period 1989 through Q1 2022, portfolios with a 30% allocation to alternatives (like private real estate) exhibit less volatility and higher average annualized returns versus a portfolio with a similar proportion allocated to just stocks and bonds. For example, a 60/40 stocks/bonds portfolio over the period yielded an 8.78% annualized return and 9.38% volatility, whereas a 40/30/30 portfolio (with 30% allocated to alternatives) yielded an improved annualized return (9.4%) and lower volatility (7.81%).

In other words, there is both historical precedent and current impetus for moving beyond a 60/40 portfolio and into alternatives like private-market real estate.


1 Source: Goldman Sachs, July 28, 2022: https://www.goldmansachs.com/insights/pages/how-to-overhaul-tried-and-tested-investment-portfolio-when-inflation-soars.html

2 Source: MorningStar, July 14, 2022: https://www.morningstar.com/articles/1102108/why-your-6040-balanced-portfolio-isnt-working-in-2022

3 Source: A Wealth of Common Sense, June 5, 2022: https://awealthofcommonsense.com/2022/06/the-worst-years-ever-for-a-60-40-portfolio/

4 Source: The Wall Street Journal, August 9, 2022: https://www.wsj.com/articles/market-rout-sends-state-and-city-pension-funds-to-worst-year-since-2009-11660009928

 

60/40 Portfolio FAQs

Q: What is a 60/40 portfolio?
A: It’s a traditional investment strategy allocating 60% of assets to equities and 40% to fixed-income investments (bonds), designed to balance risk and return by diversifying across asset classes.

Q: Why is the 60/40 portfolio model being reconsidered?
A: The changing market conditions, low-interest rates, and increased volatility have necessitated greater diversification beyond stocks and bonds. The traditional model may not offer the same level of protection or potential for returns in today’s economic climate.

Q: What are alternative investments?
A: These include assets like private equity, hedge funds, commodities, and commercial real estate, which fall outside traditional stock and bond portfolios. They can offer unique benefits, such as higher potential returns and lower correlation with traditional markets.

Q: How does commercial real estate enhance portfolio diversification?
A: It provides income generation, potential capital appreciation, inflation protection, and has a low correlation with traditional financial markets. This makes it an effective diversification tool, offering a stable income stream and potential for value growth within a diversified investment strategy.

Q: How can I start investing in commercial real estate?
A: Platforms like EquityMultiple make it easier for accredited investors to integrate commercial real estate into their portfolios, offering a variety of investment opportunities from direct property investments to real estate funds, catering to different risk and return profiles.

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Soren Godbersen
Soren Godbersen
Soren is Chief Growth Officer at EquityMultiple. Since the launch of the EquityMultiple platform in 2015, he has overseen customer communications and educational content development. Soren is responsible for the ongoing development of the EquityMultiple brand, ensuring a great investor experience, and pursuing sustainable growth for the company. Mr. Godbersen holds a Bachelor's of Arts in Economics from Whitman College, and his writing has appeared in publications such as GlobeSt and the CFA Institute's Enterprising Investor. Prior to EquityMultiple, Mr. Godbersen worked on major product development and marketing initiatives for SaaS companies. He holds a degree in Economics from Whitman College.

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