Bryan Dooley: Don’t write off the 60/40 investment portfolio yet – The Royal Gazette

Balanced portfolio: A 60/40 mix of stocks and bonds is a good starting point for an investor (Photograph by David Fox)

The traditional 60/40 portfolio, where 60% is invested in stocks and 40% in bonds, is often seen as the starting point for investors who can accept some volatility but still want to protect capital and grow capital over time.

Investment advisors then tend to adjust the mix based on each investor’s risk tolerance, time horizon and market conditions. Backed by strong risk-adjusted returns over decades, the 60/40 combination can be considered the gold standard of financial planning.

The risk-reducing feature of this strategy is that historically, when stocks suffer from recession fears, bonds tend to rally because the Federal Reserve and other central banks typically cut interest rates to support the recession. ‘economy. When interest rates fall, bond prices rise, providing a buffer for the overall portfolio, as they help cushion portfolio returns when riskier assets fall.

While in the past a diversified portfolio protected investors against sharp declines, this year was different. In fact, a US 60/40 portfolio has fallen about 15% so far this year, marking the biggest drop since 2008 as stocks and bonds fell together. Because investors expect an inflationary recession, or stagflation as it is sometimes called, asset classes of all types have been pushed lower this year.

Aggressive central bank policies, soaring inflation and the looming possibility of a global recession have conspired to hurt stock prices across the board. Every rise in stock markets seems to result in equal sales.

Last week, we saw a one-day drop of more than 1,200 points in the Dow Jones Industrial Average and a 5% drop in the Nasdaq, essentially reversing the gains of the previous week.

Some refer to a Fed “call” instead of a Fed “put”.

To explain, in years past, the Federal Reserve could be counted on to support the market in times of economic crisis. The dual mandate of the world’s largest central bank has always been to maintain price stability by controlling inflation and to keep the country at or near full employment, but in recent years the Fed has also kept a eye on the stock markets.

This is likely due to the fact that around 56% of Americans now own stocks. Even though the Fed has no explicit mandate to support the stock market, over this millennium central bankers have understood the ripple effect of market volatility on the broader economy.

However, that narrative changed with Fed Chairman Jerome Powell’s now infamous speech in Jackson Hole this summer, where he declared war on inflation.

By putting job growth on the back burner and inflation front and center, Powell and his committee can now see progress in stock prices as an invitation to raise interest rates further, giving the committee more leeway. in the war against inflation.

The old protective put can now be a restrictive call option. Some economists believe the Fed would be happy to see up to two million American jobs lost if it helped calm inflation by slowing wage increases.

Despite the hawkish rhetoric, markets have managed to stage periodic advances. Despite last week’s sell-off, the 60/40 portfolio is still in positive territory for the current quarter and its long-term track record remains intact. Going back to 1926, a balanced 60/40 portfolio has returned 8.77% per year on average with positive returns for 72 out of 94 years, according to a recent Vanguard study.

With so much written about inflation this year, it seems like everyone is now an expert on the subject. While many variables do indeed affect the level of inflation, the latest price spike boils down to one overriding factor: The Federal Reserve has simply printed too much money over the past few years and now needs to reverse the error.

Although labor shortages, supply chain bottlenecks and the war in Ukraine have contributed to higher consumer prices, history tells us that inflation essentially occurs when the money supply grows faster than national output under otherwise normal economic circumstances.

In the five years leading up to 2020 (the start of the pandemic), the US money supply had grown steadily at a rate of around 5.6% per year, using a common measure known as M2.

Then, when Covid started in early 2020, the Fed suddenly turned on the tap to a degree never seen before. In 2020 and 2021, the Fed increased the money supply by 25% per year, more than four times the normal amount.

During this period, the Federal Reserve’s balance sheet has also more than doubled, from about $4.15 trillion to $8.75 trillion at the end of last year. The Fed created money by buying bonds and mortgages for cash and these securities ended up on the balance sheet.

The Fed’s hawkish rhetoric, higher interest rates and sticky inflation are all headwinds; but investors should not underestimate the resilience of America’s strongest companies. Well-run businesses that have survived the Covid recession and the Great Financial Crisis have learned to adapt to the changing whims and ambitions of elected and unelected politicians.

We recommend continuing to focus on the best performing companies while looking for opportunities to hold both debt and equity at attractive levels.

Some investors had written off the 40% fixed-income position in the traditional 60/40 portfolio because rising rates hurt the prices of existing bond issues and current yields were paltry. Yet bond portfolios are now gradually benefiting from their ability to reinvest maturities and coupons at increasingly higher interest rates. Two-year Treasuries that paid just 0.22% a year ago are now paying around 4%!

Also in the good news category, the money supply has not increased since the start of the year and the Fed’s balance sheet has even started to shrink. This should be constructive for future inflation impressions. When the Fed finally manages to close in on its 2% inflation target, markets will applaud a moment of success and patient investors should finally be rewarded.

Bryan Dooley, CFA, is Chief Investment Officer at LOM Asset Management Limited in Bermuda. Please contact LOM at 441-292-5000 for more information. This communication is for informational purposes only. This is not an offer or solicitation to buy or sell any financial instrument, investment product or service. Readers should consult their brokers if such information and/or opinions are in their best interests when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.

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