Why the 60/40 Portfolio Diversification Strategy is Tough to Beat Consistently

It’s impossible to predict which asset classes will or will not do well in a given year. That’s the moral of the story, according to recently published portfolio and planning research from Morningstar. Areas that are winners one year often sink to the bottom in later years, but holding a variety of asset classes can help guard against being overly exposed to an area that falls out of favor.

Morningstar Portfolio Strategist, Amy Arnott, Director of Personal Finance and Retirement Planning, Christne Benz, and Manager Research Senior Analyst, Karen Zaya, hosted a webinar on April 23 to discuss the past, present, and future of portfolio diversification. Watch it on demand for free.

The topics below are covered in much more detail in the webinar.

Combining asset classes that have correlations below 1.0, as defined by Harry Markowitz’ landmark research published in 1952, can reduce a portfolio’s overall risk profile. It is one of the few cases where the whole can be more than the sum of its parts. A well-constructed portfolio can have better risk-adjusted returns than its components. The problem is that correlation coefficients shift over time, so what worked in the past won’t necessarily work in the future. Additionally, adding asset classes to reduce volatility can also drag down returns, sometimes over multiyear periods. Moreover, correlations between many assets spike during periods of market crisis—in other words, exactly when you need diversification the most.

The 2024 Diversification Landscape Report digs into the benefits of adding various asset classes and styles to a US equity portfolio, including:

• Taxable and municipal bonds in the US
• International equity
• Commodities
• Alternatives
• Sector-specific indexes
• Investment styles
• Factor indexes
• Private investments
• Cryptocurrencies

To test the value of portfolio diversification, the Morningstar team created a portfolio made up of 11 different asset classes. They allocated 20% of the portfolio to larger-cap domestic stocks; 10% each to developed- and emerging-markets stocks, Treasuries, US core bonds, global bonds, and high-yield bonds; and 5% each to small-cap stocks, commodities, gold, and REITs.

The findings indicate portfolio diversification didn't boost returns in 2023's generally bullish market environment. As US stocks bounced back from their losses in 2023, most other asset classes fell behind. In contrast to 2022, when diversification was a net positive, every “diversified” asset class fell behind the Morningstar US Market Index in 2023. As a result, the most basic version of a 60/40 portfolio (made up of US stocks and US investment-grade bonds) gained about 18% for the year, but a more diversified version fell roughly 4 percentage points behind.

As the Federal Reserve began aggressively raising rates in 2022 (spanning a period from March to December), the correlation coefficient between stocks and bonds was quick to respond. Rather than maintain a period of low rates indefinitely, the Federal Reserve moved quickly to reset rates, faster and higher than it had in decades. While rate increases in 2023 were more moderate, the recalibration has remained a significant driver behind higher stock and bond correlations. This proposed distinct monetary policy regime is referred to as the Great Unknown, and it begins with the most recent interest-rate pivot in the dataset. It reflects the unique challenges of its era: excessive inflation and asset bubbles fueled by excessively low borrowing costs.

Paradoxically, investors should find interest-rate pivots encouraging. Although painful, without these, bonds would lose their long-term diversification benefits. Inflation combined with persistently low rates detracts from a US Treasury bond's income-generating ability. And when rates sit at or near zero, the expectation that they must rise to restore elements of economic equilibrium fuels volatility in bond prices, too. Nobody wants to hold a bond knowing that aggressive rate increases are on the horizon. A higher rate reset now creates better opportunities for bonds later. Indeed, higher bond yields heading into 2023 helped offset losses from continued rate increases during the first seven months of the year.

In the webinar titled “Explore Portfolio Diversification Strategies with Morningstar Analysts” featuring Amy Arnott, Christine Benz, and Karen Zaya, they examine the rolling three-year correlations and longer-term correlation trends for many different areas, including taxable bonds, municipal bonds, style-based indexes, commodities, alternatives, factor indexes, international equity, and private investments.

For a comprehensive analysis of each asset class, download the full 52-page report. Morn

Other sections of the report include:

• 2023 Overview and Long-Term Trends
• Key Portfolio Implications
• Learning From History
• Recessionary Periods
• Inflationary Periods

Watch the webinar recorded April 23, 2024, featuring Amy Arnott, Christine Benz and Karen Zaya, on demand for free.

The data surfaced in this report was pulled from Morningstar Direct, a comprehensive platform that helps asset and wealth managers build their assets and manage their portfolios by supporting market research, product creation, positioning, marketing, and distribution strategies. Get a free 2-week trial of Morningstar Direct to see how it can improve your workflows.