The 60/40 Portfolio's 4% Trigger

The "Relative Cost" of the 60/40 Balance Portfolio skyrockets when the 10-year Treasury bond yield is below the 4% Trigger.

The 60% stocks, 40% bonds portfolio – the 60/40 – has long been a popular approach for investors.   It succeeds in providing a decent growth in wealth over time but with a significant reduction in the emotional portfolio swings of an all-in 100% stock portfolio.    Although the “balanced” 60/40 asset mix reduces volatility, it comes with the cost of a lower long-term return.

Since 1945 (chart 1), the 60/40 balanced portfolio has delivered a 9.4% average annualized total return, which is 2.2% less than the 11.6% total return achieved by the S&P 500 Index.   However, the annualized standard deviation of monthly returns for the 60/40 portfolio was only 9.7% compared to 14.6% for the S&P 500 Index.    This trade-off is well known by seasoned balanced investors – since 1945, the 60/40 portfolio has generated about 33% less volatility at a cost of about a 20% lower total return.

What may be less appreciated, however, is that the “cost” of the 60/40 mix (i.e., its underperformance relative to the 100% stock portfolio) varies widely over time depending most importantly on the level of the 10-year Treasury bond yield.    Chart 2 demonstrates the specific impact the level of the 10-year yield has had on the cost of the 60/40 combination since 1945.  This chart shows the average annualized return differential between the S&P 500 Index and the 60/40 portfolio (i.e., the “cost” of enjoying the lower volatility associated with the 60/40) for each Treasury Yield decile since 1945. The specific yield range for each yield decile since 1945 is displayed along the horizontal axis.

Clearly, the cost of investing in the 60/40 goes up considerably at lower bond yields and becomes much cheaper at higher bond yields.   What is perhaps most interesting, however, is this relationship is far from linear.    The average annualized cost of investing in the 60/40 portfolio when the bond yield is in its lowest four deciles is an alarmingly high 5.5% average annualized loss of total return relative to owning the 100% S&P 500 portfolio.  By contrast, when the 10-year Treasury yield is in its historical top six deciles, the average annualized cost of implementing the 60/40 mix is only 0.73%. 

As shown in chart 2, the upper end of the fourth decile for bond yields since 1945 is about 4%.   For whatever reasons, the cost of owning a 60/40 portfolio has historically changed radically around a 4% 10-year Treasury yield. Below a 4% yield, the average cost of the 60/40 portfolio is nearly prohibitive whereas once the bond yield rises above the 4% level, its cost becomes almost de minimis.   Essentially, at least since 1945, the 4% bond yield has acted as a “Trigger” or toggle switch significantly altering the cost of investing in the 60/40 portfolio.

I am not sure why a 4% bond yield impacts the cost of balanced portfolio so dramatically.   But my guess is it has something to do with the relationship between the 4% coupon offering for bond holders compared to the growth rate of the overall economy and what this implies for corporate profit growth.   Since 1947, overall average annualized U.S. nominal GDP growth has been 6.4%, comprised by 3.1% real GDP growth and 3.3% inflationary growth.   Over time, corporate profit growth has been slightly greater than nominal GDP growth, rising at an average annualized pace of 6.9%.   The balanced portfolio seemingly does okay as long as there is a meaningful buffer (a 4% or more coupon payment on the bond portfolio) to offset the boost the stock market receives from an almost 7% annualized profit gain.    If the bond yield is less than 4%, it hardly covers the annual inflation rate and becomes a rather paltry return relative to average profit gains for stocks.   But once the bond yield rises above 4%, the balance portion of the 60/40 can be expected to generate positive real returns and some reduction in the gap caused by profit gains accruing to stock investors. 

Whatever the reasons behind its existence, 60/40 investors need to be mindful of the 4% Trigger!

The 10-Year Treasury Yield Currently Hovers Just Above the Trigger!

This Trigger would not be very important today if the 10-year bond yield were 2% or 6%.   But, currently, the 10-year Treasury yield closed Friday at 4.4% and sits only 40 basis points from the toggle switch.   If yields keep rising in 2025, then 60/40 investors can continue enjoying a relatively low-cost investment strategy offering returns close to an all-stock portfolio with lower volatility.  However, should the 10-year yield soon again have a 3-handle, the cost of 60/40 investing is likely to skyrocket. 

As I recently discussed in earlier missives, my expectation is for economic momentum and bond yields to decline again in the coming year.   If correct, the returns from the 60/40 mix could prove more disappointing relative to overall stock market returns than expected.

Final Commet

The 60/40 balanced portfolio makes sense for many investors and there is no reason to abandon balanced management even if the 10-year Treasury yield does decline again below the 4% trigger.   However, 60/40 investors may want to consider occasionally altering the balance mix depending upon which side of the Trigger they find themselves.     If you generally are a 60/40 investor, perhaps you could adopt the simple rule of being 50/50 when above the yield Trigger and switching to 70/30 when below the yield Trigger.    Depending on each individuals’ risk tolerance, this “toggle approach” may not be appropriate.   But for those balance investors who may want to try and take advantage of the 4% Trigger and keep the “relative cost” of balanced management reasonable, adjusting the mix slightly around the toggle may prove profitable perhaps as soon as in 2025. 

If I don’t write again before, I wish you all a Very Happy Turkey Day!   I am extremely THANKFULL to each of you for subscribing and taking the time to read my missives.

Thanks for Taking a Peek! Jimp

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