‘Diversification is Back’—Why Do 60/40 Portfolios Work?

One of the most important market relations once again works in favor of investors.

After the abysmal performance of a 60/40 stock and bond portfolio mix in 2022, bonds are back and are keeping portfolios afloat during stock market declines.

A classic diversification strategy with 60% stocks and 40% bonds, the 60/40 portfolio assumes that stock prices and bond prices tend to move in opposite directions. So when stocks fall, bond prices should rise, helping to stabilize the portfolio’s returns. Even for investors who don’t have a strict 60/40 strategy, the relationship between stock and bond prices forms the critical foundation of almost any broadly diversified portfolio.

Take the third quarter, when the strategy worked well for investors. From 1 August to 5 August Morningstar US Market Index decreased by 6.28% but Morningstar US Core Bond Index It increased by 1.53%. Similarly, from September 2 to September 6, stocks fell 4.32% while bonds rose 1.27%. As a result, 60/40 portfolios fell only half as much as the overall market. “Diversification is back,” says Morningstar Indexes strategist Dan Lefkovitz.

A closer look at the latest one-day returns shows that this trend largely holds. Since the beginning of the third quarter, stocks and bonds have moved in opposite directions on the same day 43% of the time. They finished the trading day higher in 34% of cases. Only 23% of falls occurred on the same day.

Lefkovitz says there are two main reasons for 60/40’s success during this period. First, investors tend to turn to safe investments such as investment-grade bonds during market fluctuations. Second, investors predicted that the Federal Reserve would cut interest rates in September, which increased bond prices. While diversification may pay off in 2024, that’s partly due to the projected timing of rate cuts, Lefkovitz says.

2022 Was a Bad Year for 60/40

The success of 60/40 in 2024 is very different from 2022, when stocks and bonds were struggling. The US Market Index fell 19.4%, its biggest loss since 2008. Meanwhile, the US Core Bond Index experienced its worst year in history, falling 12.9%. This resulted in a total loss of 15.3%. Morningstar US Intermediate Target Allocation Index— A diversified mix of 60% stocks and 40% bonds designed as the benchmark for a 60/40 allocation portfolio. This loss was just 4 percentage points better than the overall decline in the stock market, making it the 60/40’s worst calendar year since 2008.

Whether 60/40 Works or Not

The basis of diversification is having investments with different performance characteristics. If one takes a big hit, something else in the portfolio will rise, or at least not fall too much. Underlying this is the concept of correlation, which measures the tendency of different investments to move up or down at the same time. A correlation value of 0 indicates that stocks are moving without any correlation, while a value of 1 means that stocks are seeing their gains or losses in perfect alignment. Positive readings mean direct correlation. Negative readings are known as reverse correlations.

Over the past 20 years, stocks and bonds have often been negatively correlated. But they have strong positive correlations since 2022, negating the diversification benefits of owning both. Lefkovitz emphasizes that “bonds are not monolithic” and that different types have different relationships with stocks. For example, high-yield bonds have much higher correlations with stocks than investment-grade bonds.

The 20-year average correlation between short-term treasury bills and stocks, which was negative 0.12, has jumped to positive 0.51 since the beginning of 2022. There is a positive correlation of 0.67 between long-term treasury bills and stocks since 2022. With a 20-year average of negative 0.10.

The high inflation and high return environment of the past few years has been the biggest driver of this change. “When the market expects borrowing costs to rise, Correlations between stocks and bonds often increase” writes Amy ArnottMorningstar Research Services portfolio strategist. “From a mechanical perspective, cash flows are being discounted at higher rates by investors, thus decreasing the current value of stocks and bonds,” he explains. “Furthermore, higher interest rates often reduce consumer and corporate spending, which can slow the economy and reduce corporate profitability.”

Correlations Change Over Time

However, many investors do not realize that correlations are not written down. “They are constantly on the move,” Lefkovitz says. “The relationship between entities is not stable.”

Stocks and bonds moving together can be good for investors; if both are in an uptrend. Looking back, since 2000, stocks and bonds have moved in the same direction for 18 of the 25-year period through 2024.

In 17 of these 18 periods, stock and bond returns were positive. Comparing the returns of the S&P 500 Index and the Bloomberg U.S. Aggregate Bond Index, 2022 marked the first time since the Aggregate Bond Index’s inception in 1980 that the calendar-year returns of both stocks and bonds were negative.

“Bonds rose in several equity market sell-offs ahead of 2022 when equity markets crashed,” Lefkovitz says. “So it was a big surprise that bonds didn’t rise in 2022 when stocks fell.” Bonds soared during the 2020 pandemic, the 2008 market crash and the 2002 dotcom bubble. “Investors have become accustomed to bonds acting as shock absorbers during stock market panics and selloffs,” explains Lefkovitz.

What Should Investors Do?

In his article on the subject Three lessons from the latest market drama“There is nothing permanent except change,” Lefkovitz writes. He explains that investors are learning that correlations (especially between stocks and bonds) can and do change in 2022.

But he says diversification is still valuable for investors: “Diversification is always a sensible approach in the face of uncertainty. Portfolios should be ready for a variety of scenarios. The case for owning a broad range of assets is strong, as the future rarely looks like the past.”