Nowhere to hide in 2022 - A couple of amateurs' views on whether the 60/40 portfolio is dead, broken, or not good enough.

Those who know us well know we enjoy investing.?We’re members of a couple of investment clubs where we share information and manage money together. We’ve been reading quite a few articles and listening to discussions around the 60/40 portfolio. We want to share the experience of our investment club during the 2022 drawdown and provide our humble opinion on the 60/40 investment portfolio.

Before we jump in, we want to make sure it’s clear that we are not investment professionals, and we are not paid to invest other people’s money.?We are not giving investment advice.?The thoughts shared in this article are from a couple of amateurs, albeit amateurs that have been on an active investment journey over the last 15 years.

2022 - A No-Good Bad Year

It’s clear by now that 2022 was a no-good bad year for the well-known 60/40 portfolio; typically considered a portfolio mix of 60% stocks and 40% bonds. According to Vanguard, the typical 60/40 portfolio experienced a drawdown of around 16% in 2022, but the 10-year outlook has improved. This year we’ve read numerous articles discussing whether it is dead, broken, or no longer good enough. ?Some articles have gone so far as to present options for how to fix it, reimagine it, or stick with it.

A common theme with options to fix or reimagine the 60/40 is they’re typically not backed by actual investment results. They’re typically recommendations to substitute a mix of investments on a theoretical basis and not necessarily the actual experiences of a portfolio manager through the 2022 drawdown.

Watching Market Signals

Like most investors, we’d been keeping tabs on inflation and any news regarding the Federal Reserve’s interest rate changes. We knew the Federal Reserve wanted to downsize its balance sheet (known as quantitative tightening) and needed to fight inflation through interest rate increases.?As a club, we started keying in on signals that would help us define the broader market condition and when the rate changes would occur.

In 2021, Jeremy Grantham, a well-known British investor with skill in spotting asset bubbles, was signaling U.S. stocks were in a bubble. By December 2021 Reuters reported the Federal Reserve signaled three rate hikes were in the cards for 2022. As we entered 2022 Morningstar placed the equity market at about 5% overvalued based on all the equities they cover.

Jeremy Grantham had a conversation with Christine Benz and Jeff Ptack on The Long View podcast in February 2022 where the three discussed market bubbles. What we found particularly interesting about Jeremy Grantham’s thesis is the fact he believed bonds, housing, and stocks were overpriced. By September 2022, Jeremy Grantham published an article discussing the Supperbubble’s Final Act.

To be clear, we are not permabears. We do not consistently act with the expectation asset values will fall regardless of market conditions. In our view, all the evidence leading into 2022 suggested a drawdown was expected, and because (in our view) low interest rates were driving bubbles, the drawdown would be orderly.

Based on the general rule of how bonds are impacted by rates, which we’ll touch on below, and the fact equity valuations were stretched as we entered 2022, our club believed we would be experiencing headwinds in 2022 and our success would hinge on our understanding of the impact of interest rates across the market.

Why Interest Rates Matter

An important thing to understand in finance is the risk-free rate of the ten-year treasury is a financial benchmark that influences mortgage rates, rates at which companies borrow, and acts as a risk-free rate on long-duration assets, such as stocks.

As a general rule, a 1% change in interest rates will change a bonds price by ~1% in the opposite direction for every year in duration remaining on the bond. So, a 1% increase in market rates on a newly issued ten-year bond is likely to result in a 10% drop in the face value of the bond. If you can hold the bond to maturity, it is not a problem. The failure of Silicon Valley Bank is a good example of what happens when you cannot hold your underwater bonds to maturity.

A common technique for valuing stocks is a discounted cash flow analysis. It is an analysis where future cash flows generated by the company are discounted to present using a minimum rate of return, which is often considered the risk premium. Stocks are considered long-duration risk assets, and as rates rise, the risk premium goes up and cash flows are discounted at a higher rate which results in a lower present value of future operations for the company, and this typically translates to a lower stock price.

This is why intermediate to long-term bonds as well as stocks with little to no free cash flow or lofty valuations were clobbered in 2022. Fund managers de-risked and the valuation was adjusted accordingly.

Asset Price Correlation

The primary reason the 60/40 portfolio is being questioned is that the correlation between stock and bond price movement has increased over time. The chart below is taken from Morningstar: Don’t Lose Faith in the 60/40 Portfolio | Morningstar

The reason this correlation has increased over time is that interest rates have been in decline since the early 1980s.?

The chart below paints a picture of how much rates have fallen on the ten-year treasury since the early 1980s. The peak was around 15.84% in September 1981 and the trough was around 0.55% in July 2020.

Can you imagine only receiving 0.55% for ten years? Low rates can help explain some of the investor behavior we experienced during the COVID years.

When rates dropped to near zero and the stock market took off after the Federal Reserve bailed out the economy in 2020, we grew concerned with valuations. In 2021 our concerns increased as the meme stock craze resulted in Melvin Capital losing billions during a short squeeze by retail traders.

Our club realized the market we were investing in was abnormal and we were concerned bonds and stocks may fall in tandem when rates began to rise. The challenge was we did not know how much and how fast rates would rise, or how fast inflation would fall.

We wanted to lower our risk, but how when rates were near zero?

Our Approach

We’re a club of investors, so as a rule, we remain invested, and practice diversification. We typically only hold 4%-5% of our portfolio in cash. Moving the remaining 95% of our portfolio to cash was not an option.

As we entered 2020 our portfolio was around 88% stocks, 7% bonds, and 4% cash. Our bond sleeve was 5% preferred stocks and 2% exchange-traded index bond funds.

Duration is a measure of a bonds interest rate risk. Our club employed a handful of strategies to manage the risk.

By 2022 our club had reduced our typical stock exposure from 88% to about 67% and rotated some of the portfolio to value stocks. Cash increased from our normal 4% to 10%. In lieu of investing the remaining 23% in a typical bond exchange-traded fund, we opted for a bond sleeve allocation that looked something like this as we entered 2022:

·????????Crowd Funded Private Credit and Real Estate – 15%

·????????Exchange Traded Bond Funds – 4%

·????????Preferred Stocks – 4%

Our first strategy was buying private investments (primarily private credit) on the Fundrise platform we knew would be held to maturity and would not need to be marked-to-market as interest rates increased. Our position increased from about 15% to 17% during 2022.

The second strategy was to buy on the short end of the yield curve by adding treasury bills as rates increased during 2022. Short-term treasury bills are minimally impacted as interest rates rise since they mature in a year or less. We ended up with of allocation of around 4% by the end of 2022.

The third strategy was to reduce exposure to preferred stocks since they are perpetual securities highly sensitive to interest rates. The preferred stocks were shares from two systematically important financial institutions (too big to fail banks). Our position decreased from 4% to 2% during 2022.

While not much of a strategy, we kept our exposure to broadly diversified intermediate-duration exchange-traded funds unchanged at 4%. The funds we held were a Vanguard total bond market index and an iShares investment-grade corporate bond exchange-traded fund index.

Throughout 2022 as interest rates increased our cash was deployed into treasury bills, and we opportunistically sold some stock positions and used cash to add to select existing consumer cyclical and technology positions after asset prices were depressed. By the end of 2022 our stock and bond sleeves rose to about 70% and 27% respectively.

Our Results

For 2022 our stock sleeve returned around -10.96% while our bond sleeve returned around 0.19%. With a 70/27/3 stock/bond/cash allocation by year-end the portfolio lost around -7.62% for the year.

The exchange-traded bond funds and preferred stocks experienced a significant drawdown while the Fundrise private credit, real estate, and treasury bills provided returns that offset losses in the bond sleeve. Had our club allocated a 27% weight in an indexed exchange-traded fund, such as the Vanguard Total Bond market, our bond sleeve would have experienced around a 13% drawdown, and our portfolio would have experienced a loss of around 11.2% for the year.

Even though we did not have a pure 60/40 portfolio allocation, we did have a healthy allocation to a bond sleeve. Most importantly, our bond sleeve did not have much correlation to stock returns. Our club’s real-life example demonstrated to us how important it was to consider interest rate risk when creating our bond sleeve. Our club learned if the risk of interest rates rising is high, a higher allocation to assets on the shorter end of the yield curve and assets not publicly traded can reduce correlation and smooth returns.

Our club began implementing this strategy incrementally in 2020. Since the change, our club portfolio has returned 22% more in cumulative returns above our benchmark while reducing our return standard deviation to 13.6% versus our benchmark 22%. The club is producing respectable returns while reducing portfolio volatility.

Final Thoughts

In closing, our club does not believe the 60/40 portfolio is dead or broken, but we do believe it is not good enough during periods of heightened interest rate risk. During these periods the correlation to publicly traded stocks and bonds is likely to be higher. When correlation is high, identifying strategies within the bond sleeve to manage interest rate risk is important to smoothing returns.

Steven Hellyer and Chase Kinney co-authored this article.