Executive summary

Many pundits have declared the death of the 60/40 portfolio¹ in recent years, reflecting the microscopic scrutiny of multi-asset strategies amid jarring global events. The 60/40 portfolio promotes the potential for attractive risk-adjusted returns by investing in a mix of stocks and bonds. And in spite of the ongoing global challenges, our empirical research suggests that bonds should continue to play a supporting role in well-balanced portfolios. From our perspective, the 60/40 portfolio—and diversification in general—is alive and well.

The death of the 60/40 portfolio?

Is the 60/40 portfolio dead, as many pundits have declared? The near-zero global interest rates in the decade following the Great Recession, and, more recently, the dreadful performance of both stocks and bonds in 2022, have been cited by some as the death knell of the 60/40 portfolio. This investment approach promotes the promise of attractive risk-adjusted returns by including a mix of 60% stocks and 40% bonds, offering diversification and risk factors thought to be uncorrelated.

Within a diversified portfolio, bonds offer relatively predictable coupon payments and a potential counterbalance and stability to equities and other risk assets. History teaches us that bonds often rally when equities sell off, as shifting underlying risk factors tend to fuel so-called flight to safety capital flows into bonds. Empirically, industry participants often cite observed low or negative correlations between stocks and bonds as justification for a balanced portfolio.

Questions arise regarding conventional wisdom

However, the conventional wisdom of employing a balanced portfolio of stocks and bonds has fallen under microscopic scrutiny over the past decade. Equity dividends were often competitive with fixed income yields, and stock and bond prices often moved in conjunction, sometimes sharply lower. Have bonds and the merits of a balanced portfolio lost their luster? Exhibit 1 provides context to help answer this question.

Exhibit 1: There is no alternative (TINA) to stocks
Stock dividends were competitive with fixed income yields following the Great Recession.

Sources: Schwab Asset Management; Bloomberg. Data from 12/31/1975 to 3/31/2023. For definitions and additional terms, please see https://www.schwab.com/resource/index-and-investment-term-definitions. Past performance is no guarantee of future results. Indexes are unmanaged, do not incur management fees, costs, and expenses, and cannot be invested in directly.

Surprisingly, despite low bond yields in the era following the Great Recession, 60/40 and similarly balanced portfolio performance has been remarkably resilient, primarily due to a prolonged equity bull market. Bonds may have taken a back seat during a macro environment that favored equities. Yet fixed income bolstered portfolio performance during volatile stock market drawdowns, such as the start of the global pandemic and ensuing 2020 recession. Exhibit 2 helps to illustrate these results.

Exhibit 2: The 60/40 balanced portfolio has delivered
The 60/40 portfolio has generated an attractive risk-adjusted total return over time compared to all-stock or all-bond portfolios.

Sources: Schwab Asset Management; Bloomberg. Data from 01/31/1976 to 3/31/2023. The Sharpe ratio calculation assumes a risk-free rate of 2%. The 60/40 balanced portfolio represents the combined performance of a hypothetical mix of 60% S&P 500 Index and 40% Bloomberg US Aggregate Bond Index. Past performance is no guarantee of future results. Indexes are unmanaged, do not incur management fees, costs, and expenses, and cannot be invested in directly.

Empirical evidence about correlations and performance

The recent rise in stock/bond correlations during 2022 and into the first quarter of 2023 has some investment experts questioning the merits of diversification and balanced portfolios. However, as Exhibits 3 and 4 help to demonstrate, while the long-term historical average correlation between stocks and bonds has been near-zero or negative depending on the observation period, observed correlations can vary meaningfully.

Exhibit 3: The stock/bond correlation rise is not atypical—12-month rolling correlation
The recent rise in stock/bond correlation is not atypical when compared with historical norms.

Schwab Asset Management; Bloomberg. Data from 01/31/1979 to 03/31/23. The S&P 500 Index represents stocks, and the Bloomberg US Aggregate Bond Index represents bonds. The 12-month rolling stock/bond correlation represents 12-month periods on an ongoing basis over the sampled timeframe, while the long-term average correlation represents the average for the entire period. The 90% confidence bound was constructed as 1.64 times the observed standard deviation over the period. Past performance is no guarantee of future results. Indexes are unmanaged, do not incur management fees, costs, and expenses, and cannot be invested in directly.

Exhibit 4: The stock/bond correlation rise is not atypical—36-month rolling correlation
The recent rise in stock/bond correlation is not atypical when compared with historical norms.

Sources: Schwab Asset Management; Bloomberg. Data from 01/31/1979 to 03/31/23. The S&P 500 Index represents stocks, and the Bloomberg US Aggregate Bond Index represents bonds. The 36-month rolling stock/bond correlation represents 36-month periods on an ongoing basis over the sampled timeframe, while the long-term average correlation represents the average for the entire period. The 90% confidence bound was constructed as 1.64 times the observed standard deviation over the period. Past performance is no guarantee of future results. Indexes are unmanaged, do not incur management fees, costs, and expenses, and cannot be invested in directly.

History lessons about correlation extremes

What does history teach us about 60/40 portfolio performance in the wake of high or low correlation extremes? Exhibit 5 helps to answer this question, illustrating the historical relationship between the 12-month rolling correlation of stocks and bonds, and the performance of a 60/40 portfolio over the subsequent 12-month period.

Exhibit 5: Stock/bond correlation and subsequent 60/40 performance
The historical relationship between stock/bond correlation and subsequent 60/40 portfolio performance is positive.

Sources: Schwab Asset Management; Bloomberg. Data from 02/28/1976 to 3/31/2023. The S&P 500 Index was used to represent the performance of stocks and the Bloomberg US Aggregate Bond Market Index was used to represent the performance of bonds and the 60/40 portfolio. Past performance is no guarantee of future results. Indexes are unmanaged, do not incur management fees, costs, and expenses, and cannot be invested in directly.

Somewhat surprisingly, the observed relationship between correlation and forward return in the Exhibit 5 scatter plot chart is positive,meaning that the 60/40 portfolio performance was persistent despite increased correlation. Said differently, when correlation was elevated (like in early 2023), 60/40 performance has historically been positive and higher. At a minimum, we can say that a high observed correlation does not necessarily predict poor subsequent 12-month performance, a critique purported by some pundits.²

An atypical year that generated painful results

Stocks and bonds suffered painful losses in 2022—the S&P 500 Index finished the year 19% lower and the Bloomberg US Aggregate Bond Index—one of the most widely watched bond market indexes—fell 13%. Indeed, 2022 was the worst performing calendar year in the bond index’s history.³

In the leadup to 2022, both equities and fixed income had become increasingly expensive, with the trailing 12-month price-to-earnings, or “P/E,” ratio of the S&P 500 Index at 25.76 and yield to worst on the Bloomberg US Aggregate Bond Index at 1.75% as of the end of 2021. For equities, the P/E ratio indicates how expensive a company’s share price is relative to its earnings per share, and, for fixed income, lower yields may indicate higher bond prices. As Exhibit 6 shows, stocks and bonds do not usually have such unfavorable valuations at the same time.

Exhibit 6: Expensive valuations heading into 2023
Stocks and bonds were expensive by historical standards heading into 2023.

Sources: Schwab Asset Management; Bloomberg. Data from 01/31/1991 to 3/31/2023. This chart shows the trailing 12-month price-to-earnings (P/E) ratio of the S&P 500 Index on the left axis, and the inverse value of the yield-to-worst of the Bloomberg US Aggregate Bond Index on the right axis. Past performance is no guarantee of future results. Indexes are unmanaged, do not incur management fees, costs, and expenses, and cannot be invested in directly.

Invasion roils an optimistic outlook

While the mood early in 2022 may have been optimistic as COVID-19 vaccines rolled out and economies and societies around the world began to emerge from quarantine, Russia shocked the world and roiled financial markets by invading Ukraine in late February 2022. Geopolitical disruptions, coupled with lingering supply chain issues resulting from pent-up demand and locked down economies, pushed prices for goods and commodities higher, prompting unprecedented monetary policy tightening by global central banks in an attempt to quash inflation that had risen to levels not seen in 40 years.

The unfavorable starting valuations for stocks and bonds coming into 2022 compounded the previously mentioned challenges, collectively forming somewhat of a perfect performance storm for 60/40 and balanced portfolios last year. Since 1977, there have only been two calendar years when both the S&P 500 Index and the Bloomberg US Aggregate Bond Index finished negative (2022 and 1994). Exhibit 7 demonstrates this point.

Exhibit 7: An atypical performance year in 2022
Last year was one of only two calendar years since 1977 to experience negative performances by stocks and bonds.

Sources: Schwab Asset Management; Bloomberg. This exhibit shows positive (up) and negative (down) total returns for the S&P 500 Index and the Bloomberg US Aggregate Bond Index for the 46 calendar years from 1977 to 2022. Past performance is no guarantee of future results. Indexes are unmanaged, do not incur management fees, costs, and expenses, and cannot be invested in directly.

If we look at monthly returns instead of calendar year returns over the same period, stocks and bonds experienced a negative return in only 16% of the months. In almost 40% of the months, stocks and bonds moved in opposite directions, providing evidence of diversification. Exhibit 8 shows the incidence of positive vs negative stock and bond returns for monthly intervals.

Exhibit 8: Stocks and bonds rarely fall together
Months where the performances of stocks and bonds were both negative have generally been the exceptions.

Sources: Schwab Asset Management; Bloomberg. This exhibit shows positive (up) and negative (down) total returns for the S&P 500 Index and the Bloomberg US Aggregate Bond Index for the 46 calendar years from 1977 to 2022. Past performance is no guarantee of future results. Indexes are unmanaged, do not incur management fees, costs, and expenses, and cannot be invested in directly.

Given these yearly and monthly empirical findings, added to the comparatively favorable starting point for stocks and bonds in 2023, the historically poor performance of the 60/40 portfolio in 2022 seems unlikely to repeat in 2023.

Where do we go from here?

Any investors feeling jittery coming into 2023 were likely in good company. Many, if not all, macro and geopolitical risks that surfaced during 2022 remained in place through 2023’s first quarter, including the war in Ukraine. Moreover, while inflation may have peaked, it remains elevated and will take time to subside to more historically neutral levels. A deeply divided Congress will need to find a bipartisan solution to the debt ceiling, and, as of the end of the first quarter of 2023, the precipitous rise in interest rates has materially impacted bank balance sheets and left depositors skittish, as evidenced by the collapse of Silicon Valley Bank and Signature Bank. The debates of a soft versus hard landing for the U.S. economy are still ongoing, though, at the time of writing, most market participants believed that a U.S recession is inevitable.⁴ So, what does history tell us about stock and bond correlations during periods of high inflation or leading up to or after recessions?

Empirically, we find that periods of high inflation tend to be associated with high stock/bond correlations, a result that we quantified in Exhibit 9. History therefore suggests that correlations may remain elevated throughout 2023, although we have already illustrated that correlation is not necessarily indicative of forward performance.

Exhibit 9: High inflation tends to drive up correlations
Periods of high inflation tend to be associated with high stock/bond correlations.

Sources: Schwab Asset Management; Bloomberg. We define a “high inflation period” as one where the year-over-year change of the Consumer Price Index for All Urban Consumers (CPI-U) is greater than or equal to 4.5%. The 4.5% threshold is approximately the 75th percentile of the CPI-U since 1976. Past performance is no guarantee of future results.

Looking at the historical pattern of stock and bond correlations leading up to and after official recessions (as designated by the National Bureau of Economic Research), we cannot make any strong conclusions and elevated correlations have historically been neither predictive nor indicative of a recession. Correlations have tended to normalize after recessions have officially ended, although this has not always been the case.

Long live the 60/40 portfolio!

While the events of the past few years have certainly been jarring, there is no empirical evidence to suggest that there have been structural changes to the historical relationship between stocks and bonds. As a result, we believe that the 60/40 portfolio heuristic is alive and well. Moreover, the importance of including a potential range of fixed income allocations within a well-diversified portfolio is just as relevant for investors today, as ever. With recent bond yields at levels not seen in the past decade,⁵ we believe bonds will play a large role in balanced portfolios going forward, providing substantial income and continuing to support portfolio performance with stability and lower risk than equities. This relationship is demonstrated in Exhibit 10, which reveals the risk-related benefits that have become available when including a range of fixed-income allocations in a well-diversified portfolio of stocks and bonds.

Exhibit 10: Fixed income can help lower portfolio volatility
The range of annual total returns from 1970 to 2022.

Sources: Schwab Center for Financial Research; Morningstar, Inc. Data from 1970 to 2022. Stocks are represented by the S&P 500 Index and bonds are represented by the Ibbotson U.S. Intermediate Government Bond Index. The return figures are the average, the maximum, and the minimum annual total returns for the hypothetical portfolios represented in the chart and are rebalanced annually. Returns include reinvestment of dividends, interest, and capital gains. Past performance is no guarantee of future results. For illustrative purposes only.

Investing in both stocks and bonds provides exposure to different risk factors and investors can benefit from this diversification—even during periods of elevated correlations. A balanced portfolio approach has helped investors weather myriad storms over recent decades, while enhancing risk-adjusted returns amid high inflation, recession, and market turmoil—obstacles that may remain relevant for investors as 2023 continues to evolve.