60-40 Is Looking Tired

Back in the 19th century, one of the rallying cries for this country’s zealous westward expansion was “54-40 or fight!”, a war whoop referring to the latitude of the disputed northern border of Oregon Country.

In the 20th and 21st centuries, portfolio managers have touted a numeric acclamation of their own. You know it as “60/40,” the classic equity/fixed income mix. By throwing 60 percent of a client’s assets into the stock market and 40 percent into bonds, the thinking goes, you’ll be diversified enough to successfully ride out most market cycles. By and large, that allocation’s worked pretty well over the past few years.

The current environment isn’t like most market cycles, though. Low yields and volatility have pushed and pulled reward-to-risk ratios out of their historic shapes, prompting many advisors to consider allocations to alternative investments (“alts”) to diversify away some rebound risk. Nowadays, “60/40” is giving way to “50/30/20,” an apportionment that makes room for alts with carve-outs from both the equity and fixed-income sides.

Here’s the case for alts:

If you held a simple “60/40” portfolio consisting of investable proxies for the S&P 500 Index and the Barclays Aggregate Bond Index over the past decade, you might have thought that the large bond allocation would have loosened your ties to the equity market. Not so, however. Your portfolio’s r-squared (r²) coefficient would have been 95.50, indicating that most all of its variance could be explained by gyrations in the S&P benchmark.  

Still, your bond allocation would have dampened the portfolio’s volatility and improved its risk-adjusted return compared to a straight stock allocation. The “60/40” mix earned a .87 Sharpe ratio versus a .61 value for the S&P 500 in the last ten years. Think of the Sharpe ratio as excess return per unit of volatility. A ratio of “1” (1.00) represents a good return for the risk undertaken; “2” is very good and “3” is exceptional. The relatively low Sharpe ratio for the classic allocation in the past decade reflects the deep swoon in security prices during the 2008-2009 financial crisis.