October felt to us like a continuation of September as the stock market indexes we follow had a rough go of it, with all seven posting a negative return for the month. Most are now negative for the year as well. Bonds, as measured by the Bloomberg Aggregate index were also down (as yields continue to drift higher), as was the commodities index. The US Dollar, up slightly for the month, remains strong.
All data as of 10/31/2023, Source: Wells Fargo Investment Institute. An index is not managed and not available for direct investment. Past performance is not a guarantee of future results. [Wells Fargo Investment Institute, Inc. is a registered investment advisor and wholly-owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.]
Last month we took a dive into the current interest rate environment and gave our perspective on how it has affected the economy as well as the stock market. That analysis focused more on what had happened in the recent past into the present. This month we want to think bigger picture and focus in on not just next month or next year, but what the next decade may look like for investors and what the best strategy may be going forward.
Know Your Timeframe
Before we discuss the markets and asset allocation, we think it is important to discuss investor timeframe. In our experience when the markets are performing well many are long-term investors. However, when volatility arises so do investor jitters. The greater the short-term losses, it seems, the greater the emotions we see from investors. In our experience, periods of short-term pain make many an investor question the long-term strategy for the relative comfort of perceived short term “safety” (however they may define it at that moment in time).
When planning for our clients, a baseline assumption is that longevity will be an important factor. According to the Longevity Illustrator, a tool that constructs survival probabilities for couples using UK Social Security data, for a couple who are both 65 years old and in average health, there is a 22% chance that one of them will live to age 100. With this in mind, from an investment planning perspective, the timeframe for a 70-year-old couple is measured in decades, not months or years. Such a long investment horizon often requires taking on some degree of stock market risk to meet the investor’s goals.
Investing in stocks and bonds involves inherent volatility, defined as the degree of variation or fluctuation in the prices or returns of these assets over time. Volatility is influenced by many factors, such as market conditions, economic events, investor sentiment, supply and demand, and company performance. Volatility can affect the risk and return of an investment portfolio, as well as the investor’s emotions and behavior.
We believe diverting from a long-term plan because of short-term volatility is a mistake for three reasons:
- First, having and staying with a long-term investment plan can help investors avoid these emotional and impulsive decisions that are often driven by market fluctuations and short-term noise. By focusing on the long-term performance and fundamentals of their investments, rather than the daily or monthly price movements, investors can reduce the risk of overreacting to market events and making costly mistakes.
- Second, having a long-term investment plan can help investors benefit from the power of compounding, which is the process of earning interest on interest over time. By reinvesting their returns and holding their investments for longer periods, investors can increase their wealth exponentially and take advantage of the effects of compounding.
- Third, a long-term investment plan may also help investors reduce the impact of taxes and fees on their returns, as they can defer or minimize capital gains taxes and transaction costs by holding their investments for longer periods.
While saving for a down payment on a house or a wedding will have a short-term time horizon with a defined end date, retirement is a long-term endeavor that we believe requires a long-term investment perspective.
The 60/40 Investment Portfolio
The 60/40 investment allocation model is a classic strategy that divides a portfolio between 60% stocks and 40% bonds. The goal is to balance the risk and return of the portfolio, as stocks offer higher potential growth but also higher volatility, while bonds have traditionally offered lower returns but also lower risk and more stability. At Magellan we have utilized this allocation for many clients, dialing up or down the stock allocation based on the individual client’s risk profile, point in life, as well as their specific investment needs.
However, the 60/40 portfolio (60% equities, 40% bonds) has faced some criticism in recent years with some observers saying it is “dead.” From our perspective, asset allocation wasn’t dead, performance lagged against indexes like the S&P500 problems when interest rates were historically low between 2009 and 2022, for a few reasons:
- Lower bond yields. Low interest rates mean low bond yields, which generally reduces the income and diversification benefits of bonds. According to our own research, the average yield on 10-year US Treasury Bonds was only 2.33% between 2009 and 2022, compared to 5.68% between 1980 and 2008. Low bond yields also imply that bond prices are high, which increases the risk of capital losses if interest rates rise in the future.
- Higher stock valuations. Low interest rates also mean low discount rates, which may increase the present value of future cash flows and boost stock prices. According to our own research, the average price-to-earnings ratio of U.S. stocks was 23.6 between 2009 and 2022, compared to 15.8 between 1926 and 2008. Higher stock valuations also imply that stocks are more expensive and offer lower expected returns in the future.
- Reduced diversification. Low interest rates also mean that the correlation between stocks and bonds typically becomes more positive, meaning that they tend to move in the same direction. According to BlackRock, the correlation between U.S. stocks and bonds was 0.26 between 2009 and 2022, compared to -0.07 between 1928 and 2008. Positive correlation reduces the diversification benefits of bonds and increases the overall risk of the portfolio.
In conclusion, the 60/40 portfolio encountered some challenges when interest rates were historically low between 2009 and 2022, such as lower bond yields, higher stock valuations, and reduced diversification. These challenges may have reduced the effectiveness of the 60/40 portfolio as a balanced and optimal investment strategy for long-term investors.
Is Asset Allocation (and the 60/40) portfolio dead?
Based on JPMorgan’s 2024 Capital Markets Assumptions, there are some positives for the 60/40 portfolio over a 10-year time horizon, such as:
- Higher expected returns. The 60/40 portfolio has a compound return of 5.19% in U.S. dollar terms, which is higher than the expected returns of U.S. cash -2.51%, U.S. intermediate treasuries -1.52%, U.S. long treasuries -0.59%, and world government bonds hedged -3.27%. JPMorgan suggests higher expected returns are driven by their anticipation for strong performance of stocks, which have a compound expected return of 7.10% for U.S. large cap, 7.10% for U.S. mid cap, and 7.10% for U.S. small cap, according to the report.
- Moderate risk level. The 60/40 portfolio has an annualized volatility (standard deviation) of 5.92%, which is lower than the volatility of most equity asset classes, such as U.S. large cap 10.76%, U.S. mid cap 11.70%, U.S. small cap 12.39%, MSCI EAFE Index 11.70% and emerging markets equity 14.85% The moderate risk level expectation reflect the potential diversification benefits of bonds, which have had lower volatility and negative correlation generally with stocks.
Resilience to inflation shocks. The 60/40 portfolio has a negative correlation of -0.06 with U.S. inflation, meaning that it is expected to perform well when inflation is low or falling, and vice versa. However, the 60/40 portfolio also has some exposure to inflation-protected securities (TIPS), which have a positive correlation of 0.83 with inflation, meaning that they tend to perform well when inflation is high or rising, and vice versa. Therefore, the 60/40 portfolio may hedge against both inflation and deflation risks.
We do not believe that Asset Allocation is dead. In fact, given the current investment environment, we believe spreading your investment assets out between various asset classes makes good sense for most investors and investment goals moving forward. The 60/40 portfolio one example of a simple and historically effective investment strategy that may offer attractive long-term returns with moderate risk and resilience to inflation shocks.
So, while we truly believe that Asset Allocation will continue to work in the future, only an investment plan analysis can tell you what works best in your individual situation.
For More Information About our Investment Plan Analysis, Contact Our Team Of Financial Advisors Today!
4 According to Macrotrends, the average price-to-earnings ratio of U.S. stocks was 23.6 between 2009 and 2022, based on the trailing 12-month earnings of the S&P 500 index. This is higher than the historical average of 15.54 for the S&P 500 since 1926, as reported by stocksoftresearch.com.
6 It should be noted that by investing in the 60/40 portfolio the investor may be sacrificing returns. A 60/40 portfolio may outperform an all-equity portfolio while the stock market is down. However, equities tend to have better long-term returns than bonds. Also, market dynamics can change, which could potentially lower returns for stocks and/or bonds and thus the potential returns for the 60/40 portfolio.
On behalf of Magellan Financial we would like to thank you for taking the time out of your busy day to take in our thoughts and opinions. If you found this helpful, please forward it on to others. If you have any questions on the materials presented, would like to be added to our email list, or would like our help with your investments, we can be contacted at 610-437-5650 or via email.
Wells Fargo Advisors Financial Network did not assist in the preparation of this report, and its accuracy and completeness are not guaranteed. The opinions expressed in this report are those of the author(s) and are not necessarily those of Wells Fargo Advisors Financial Network or its affiliates. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Additional information is available upon request.
Asset allocation and diversification are investment methods used to help manage risk. They do not guarantee investment returns or eliminate risk of loss including in a declining market.All investing involves risks including the possible loss of principal invested. Past performance is not a guarantee of future results.
Index returns are not fund returns. An index is unmanaged and not available for investment.
Dow Jones Industrial Average: The Dow Jones Industrial Average is a price-weighted index of 30 “blue-chip” industrial U.S. stocks.
S&P 500 Index: The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market value weighted index with each stock’s weight in the Index proportionate to its market value.
S&P Midcap 400 Index: The S&P Midcap 400 Index is a capitalization-weighted index measuring the performance of the mid-range sector of the U.S. stock market, and represents approximately 7% of the total market value of U.S. equities. Companies in the Index fall between the S&P 500 Index and the S&P SmallCap 600 Index in size: between $1-4 billion.
S&P Small-Cap 600 Index: The S&P SmallCap 600 Index consists of 600 domestic stocks chosen for market size, liquidity (bid-asked spread, ownership, share turnover and number of no trade days) and industry group representation. It is a market value-weighted index (stock price times the number of shares outstanding), with each stock’s weight in the index proportionate to its market value.
MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI.
MSCI World Index: The MSCI World Index is a free float-adjusted market capitalization index that is designed to measure global developed market equity performance.
MSCI EAFE® Index: The MSCI EAFE Index is designed to represent the performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the U.S. and Canada.
MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets.
The CRB (Commodity Research Bureau) Index measures the overall direction of commodity sectors. The CRB was designed to isolate and reveal the directional movement of prices in overall commodities trades.
Bloomberg Barclays U.S. Aggregate Bond Index: Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based measure of the investment grade, US dollar-denominated, fixed-rate taxable bond market.
NASDAQ Composite Index: The NASDAQ Composite Index measures the market value of all domestic and foreign common stocks, representing a wide array of more than 5,000 companies, listed on the NASDAQ Stock Market.
Russell 2000® Index: The Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represents.
U.S. Dollar Index (USDX) measures the value of the U.S. dollar relative to majority of its most significant trading partners. The index is similar to other trade-weighted indexes, which also use the exchange rates from the same major currencies.
Technical analysis is only one form of analysis. Investors should also consider the merits of Fundamental and Quantitative analysis when making investment decision. Technical analysis is based on the study of historical price movements and past trend patterns. There is no assurance that these movements or trends can or will be duplicated in the future.
Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations.
Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility.
Investments in fixed-income securities are subject to market, interest rate, credit and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline of the bond’s price. Credit risk is the risk that the issuer will default on payments of interest and/or principal. The risk is heightened in lower rate bonds. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity.
Investing in commodities is not suitable for all investors. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investments in commodities may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity. Exposure to the commodities markets may subject an investment to greater share price volatility than an investment in traditional equity or debt securities. The prices of various commodities may fluctuate based on numerous factors including changes in supply and demand relationships, weather and acts of nature, agricultural conditions, international trade conditions, fiscal monetary and exchange control programs, domestic and foreign political and economic events and policies, and changes in interest rates or sectors affecting a particular industry or commodity. Products that invest in commodities may employ more complex strategies which may expose investors to additional risks, including futures roll yield risk.