The 60/40 portfolio: where does it come from and why do we use it? – The best interest

As a new green investor climbs the ladder of investment education, it won’t be long before he meets the next one 60/40 portfolio. 60% stocks, 40% bonds. Time-tested and as old as time… or, at least, that’s how it’s presented to us.

But where does the 60/40 come from?

Why those percentages? Why is it good for your pension?

In a world where we can prescribe an asset allocation specifically for one unique financial circumstances of the family, why do we keep discussing this 60/40 portfolio?

The birth of 60/40

The 60/40 has its origins in Harry Markowitz and ‘modern portfolio theory’ (MPT).

MPT is a big reason why we are here. Markowitz won a Nobel Prize for this work and discovered that diversification was truly a “free lunch” in investing. Perhaps the only free lunch. By properly diversifying your assets, you can maintain satisfactory returns while reducing portfolio volatility.

This ratio of “return divided by volatility” is important. It is often referred to as ‘risk-adjusted returns’. We know that if we take more risks, we should receive more returns. But is that always the case? “Risk-adjusted returns” attempt to level the playing field, allowing you to compare many different assets.

There are a number of good ways to visualize these risk-adjusted returns.

One is through the ‘efficient frontier’, which shows a set of optimal investment portfolios that offer the highest expected return for a given level of risk. Or in other words: the lowest risk for a certain expected return. The efficient frontier includes only risky assets.

Another is the ‘capital market line’. It is similar to the efficient frontier, but adds risk-free assets to the mix. It represents the most efficient risk-adjusted portfolios that combine a risk-free asset with a market portfolio.

If we plot the CML specifically for stock/bond portfolios on the efficient frontier (as in the chart above), we find a “tangency portfolio”** somewhere between 50/50 and 70/30.

**Rangens = where a line just touches a curve.

This ‘tangent portfolio’ is the mathematically optimal mix of these specific assets according to Modern Portfolio Theory.

This is the birth of the 60/40 portfolio. Historically, it has been the most efficient way to take risks. It is the best way to combine stocks and bonds as your goal is to get the best return/volatility ratio.

Why 60/40 makes sense

We determined that the clunky, nerdy math suggests that the 60/40 portfolio makes sense. But inadvertently, it’s also a great portfolio allocation for retirees.

From an asset-liability matching perspective, the 60/40 portfolio is great. 40% of the portfolio consists of bonds. If we work backwards from safe withdrawal rates (4%, 5%, whatever your preference), you might find that ~40% in bonds could represent 8 to 10 years of retirement spending. This turns out to be a great buffer against the risk of successive returns.

60/40 is also a great behavioral portfolio. Most people don’t care about efficient frontier or Sharpe ratios. But her Doing know they say it “Don’t put all your eggs in one basket.” The 60/40 portfolio scratches that itch.

We’re going to be optimistic about long-term growth at 60% of your assets. We are going to be careful and conservative with 40% of your assets. We expect that there will be some “ebb and flow” over time (“lack of correlation”), which is good for you as an investor.

It allows investors to participate in the bull markets while providing ballast during the bear markets.

I’m not saying the 60/40 is perfect. But it checks many boxes for the average investor.

60/40 and the 4% rule

As I mentioned, the 60/40 portfolio also plays very well with safe retirement withdrawal rates, such as the 4% rule. The 4% rule was originally created assuming a 50/50 portfolio… not far removed from the 60/40 mix.

We can rewrite “4%“as”25x.” As in – you need 25x your annual withdrawal amount in retirement. [1 / 4% = 25]

The 60/40 portfolio can therefore be seen as 10 years of bonds + 15** years of shares. I know we want a portfolio of assets to behave in harmony, and it’s not always smart to parse the assets this way. But follow me for a moment.

The ten year bonds buy us time. The first ten years after retirement can, if necessary, be financed with reliable, low-volatility bonds. This time can be important for two reasons:

• On the pessimistic side, these ten years without stocks can help us avoid the risk of a sequence of returns. The most powerful return risk occurs in years 1 through 6 of your retirement, declining rapidly in year 10.
• On the optimistic side, this decade without stocks is causing a deterioration. The “15 year” stocks we retired with could easily be that double in value during the first ten years. Suddenly our entire remaining lifespan appears to be fully funded.

Downside protection + upside potential.

That’s a powerful mix.

What about *other* assets?

Invariably, the 60/40 portfolio is accused of being too boring, too vanilla, too much ‘white shirt + jeans’.

That’s fair. To know:

• The 60/40 portfolio is not a law of nature. It is a historically favorable mix of growth assets and income-generating ballast. Seasons change, and so do our thoughts about the 60s/40s.
• Stocks and bonds may be more correlated than we once thought. See: 2022. 60/40 works best when bonds rise during a decline in stock prices. That relationship is not guaranteed.
• Adding assets is about diversifying the underlying economy. The goal is not to “beat 60/40” every year. We want to hold assets that behave differently in inflation, deflation, growth and recession conditions.

Some common assets that investors add (and some commentary on them) include…

• Real Assets (REITs, commodities, infrastructure). Real assets tend to respond well to inflation and real economic activity – risks that bonds struggle with.
• TIPS. Inflation-protected bonds, as the name suggests, address inflation risk more directly than nominal bonds.
• Alternatives. The wide, wide, wide world of ‘alternatives’. Be careful here. If done right, alternatives can deliver true non-correlation with stocks and bonds. However, sometimes alts are prohibitively expensive. Other times the alts are “putting lipstick on a pig” (there’s still a pig underneath). Other times the ‘non-correlation’ is a simple accounting trick. If you only mark to market once a quarter, Naturally you will look much more stable than stocks and bonds that are marked to market every day.

Further reading and summary

Here are some other great posts about the 60/40 portfolio:

I am convinced that there are thousands of ways to get investing “wrong”, but also many ways to get investing “right”. Many portfolios are ‘good enough’.

Can we move from “good enough” Unpleasant “perfect!” ?? I am convinced that we will only know that afterwards. So I think it’s best to find something that’s “good enough” for your situation, that you can stick with through thick and thin.

The 60/40 remains an excellent candidate for exactly that.

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