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The “60/40 portfolio” has long been revered as a trusty guidepost for a moderate risk investor—a 60% allocation to equities with the intention of providing capital appreciation and a 40% allocation to fixed income to potentially offer income and risk mitigation. In recent years as equities have marched to new highs and interest rates have descended to new lows, a simple mix of 60% US large cap stocks and 40% investment grade bonds would have likely satisfied most investors. However, in a buy-low, sell-high world, elevated valuations and low rates would suggest lower future returns for such a portfolio. So what should you expect when you’re expecting lower returns?
Investors must first come to terms with the reality that the stellar returns of recent years are likely to be more challenged. For context, the classic 60/40 portfolio has generated an impressive 11.1% annual return over the last decade. Even after adjusting for inflation, its 9.1% annual real return stands above long-term levels of around 6%1. We find that these high returns have given rise to a feeling amongst investors that “what has worked will continue to work”—a behavioral misstep known as recency bias. However, it’s easy to forget that returns haven’t always been so easy to come by. Recall not all that long ago the infamous “lost decade” to begin the 2000s in which a 60/40 portfolio generated a meager 2.3% annual return and investors would have lost value on an inflation-adjusted basis. While we can’t know what the future will hold, we think investors should at the very least recalibrate expectations, especially considering the potential for higher inflation that could take a bite out of returns.
Source: Goldman Sachs Asset Management and Bloomberg. As of 8/31/21. “Lost Decade” refers to 1/1/2000-12/31/2009. “Last Decade” refers to 9/1/2011-8/31/2021.
Recalling the classic stages of grief, once investors have overcome denial and accept the likelihood of lower future returns, it’s time to establish a new strategy. One step investors can take to potentially improve outcomes is to incorporate higher income-producing asset classes into portfolios. In a lower return environment, we think the stability of total returns can be enhanced by increasing the component coming from income, which tends to be more reliable than price appreciation. Today, a 60/40 portfolio yields less than 2%—a far cry from 5%+ offered in the ‘70s, ‘80s, and early ‘90s. In the equity market, investors can potentially boost income outside of the most familiar US large caps by considering global real estate, global infrastructure and Master Limited Partnerships (MLPs). On the fixed income side, asset classes like corporate high yield, municipal high yield, bank loans, and emerging market debt may help increase income and have historically shown little sensitivity to changes in interest rates.
Source: Morningstar, Goldman Sachs Asset Management. Distribution rates generally represent the asset-weighted median 12-month yield of representative Morningstar peer groups through 12/31/2020. Please see end disclosures for asset class definitions and important disclosures. Past performance does not guarantee future results, which may vary.
Given that most asset classes have experienced above average returns over the last decade, investors owning a simple 60/40 portfolio have been rewarded for holding the asset classes most familiar to them. However, with US large cap equity valuations in the 97th historical percentile and US Treasury yields only marginally off the all-time lows reached last year, we believe investors will need to think outside the box in their search for returns2. Through our review of several thousand professionally managed investment portfolios via our GS PRISMTM portfolio analysis, we find the most traditional types of equities representing an outsized proportion of many portfolios. The average “moderate” risk portfolio we have analyzed has nearly 80% of its risk coming from core equities3. In our view, this results in an under-representation of other attractive return-generating asset classes. In addition to the income-producing asset classes previously introduced, we see long-term opportunities in emerging market equities, international small caps, liquid alternatives, and private assets, all of which we see many investors not having any exposure. In our view, this range of assets classes offers the potential for return-enhancement, alpha generation, and diversification by spreading out risk concentrations within portfolios.
For all intents and purposes, we think investors have many reasons to be concerned that the 60/40 might be dead. And although most investors typically don’t hold such a simplistic portfolio, we see shades of the classic 60/40 present in many portfolios due to an overconcentration in the most familiar asset classes. We believe investors should recalibrate their return expectations, increase the component of performance coming from income, and consider diversifying into less familiar return-enhancing asset classes.
1“Long-term” returns reference the last 45 years dating to the inception of the Bloomberg US Aggregate Bond Index in 1976. All returns reflect a blend of 60% S&P 500/40% Bloomberg US Aggregate Bond Index. “Nominal Returns” do not reflect the impact of inflation while “Real Returns” are adjusted for inflation. Past performance does not guarantee future results, which may vary.
2Source: Robert Shiller and Goldman Sachs Asset Management as of 6/30/21. Equity valuation referenced is the Cyclically Adjusted Price-to-Earnings (CAPE) Ratio.
3Source: Goldman Sachs Asset Management as of 6/30/21. GS PRISMTM is a tool that analyzes the asset allocations of advisor portfolios. The average “moderate” risk portfolio refers to 1,600+ portfolios analyzed with a 30-40% allocation to core fixed income. “Core equities” refer to US large-, mid-, and small caps and international developed large caps. Diversification does not protect an investor from market risk and does not ensure a profit.