‘Diversification Is Back’—Why 60/40 Portfolios Are Working

One of the most important market relationships again works in investors’ favor.

After an abysmal performance for the 60/40 stock and bond portfolio mix in 2022, bonds are back and keeping portfolios afloat during stock market declines.

The 60/40 portfolio—a classic diversification strategy comprising 60% stocks and 40% bonds—assumes stock prices and bond prices tend to move in opposite directions. So when stocks fall, bond prices should rise and help smooth out a portfolio’s returns. Even for investors who don’t have a strict 60/40 strategy, the relationship between stock and bond prices is a critical foundation of just about any broadly diversified portfolio.

Take the third quarter, when the strategy worked well for investors. From Aug. 1 to Aug. 5, the Morningstar US Market Index fell 6.28%, but the Morningstar US Core Bond Index was up 1.53%. Similarly, from Sept. 2 to Sept. 6, stocks were down 4.32% while bonds were up 1.27%. As a result, 60/40 portfolios fell only half as much as the overall market. “Diversification is back,” says Morningstar Indexes strategist Dan Lefkovitz.

Looking more closely at recent one-day returns, this trend largely holds. Since the start of the third quarter, stocks and bonds moved in opposite directions on the same day 43% of the time. 34% of the time, they ended the trading day up. Only 23% of the time did they fall on the same day.

Lefkovitz says there were two primary reasons for the success of the 60/40 during this period. Firstly, investors tend to flock to safe investments such as investment-grade bonds during market volatility. Secondly, investors anticipated the Federal Reserve would cut interest rates in September, which drove up bond prices. So although diversification worked in 2024, Lefkovitz says it was partially thanks to the projected timing of the rate cuts.

2022 Was a Bad Year for the 60/40

The 60/40’s success in 2024 is a stark difference from 2022, when stocks and bonds both struggled. The US Market Index fell 19.4%, its biggest loss since 2008. Meanwhile, the US Core Bond Index had its worst year in history, down 12.9%. This combined for a 15.3% loss on the Morningstar US Moderate Target Allocation Index—a diversified mix of 60% equities and 40% bonds designed as a benchmark for a 60/40 allocation portfolio. That loss was just 4 percentage points better than the overall stock market’s decline, marking the 60/40’s worst calendar year since 2008.

When 60/40 Does and Doesn’t Work

At the heart of diversification is owning investments with different performance characteristics. If one takes a big hit, something else in the portfolio goes up, or at least doesn’t fall very much. Underlying that is the concept of correlation, which measures the tendency of different investments to move up or down simultaneously. A correlation reading of 0 indicates stocks are moving with no relationship, while 1 means they see gains or losses in perfect unison. Positive readings mean direct correlations. Negative readings are known as inverse correlations.

Over the past 20 years, stocks and bonds have been negatively correlated most of the time. However, since 2022, they’ve had strong positive correlations, which removes the diversification benefits of owning both. Lefkovitz emphasizes that “bonds are not a monolith,” and different types have different relationships with stocks. For example, high-yield bonds have much higher correlations with stocks than investment-grade bonds.

The correlation between short-term treasury bonds and stocks, which has a 20-year average of negative 0.12, has jumped to positive 0.51 since the start of 2022. Long-term Treasury bonds have had a positive 0.67 correlation with stocks since 2022, compared with the 20-year average of negative 0.10.

A large driver of the shift was the environment of high inflation and high yields over the past few years. “When the market expects borrowing costs to climb, correlations between stocks and bonds typically increase,” writes Amy Arnott, portfolio strategist for Morningstar Research Services. “From a mechanical perspective, cash flows are discounted by investors at higher rates, thereby decreasing the current value of stocks and bonds,” she explains. “Moreover, higher interest rates often dampen consumer and corporate spending, which can slow the economy and reduce corporate profitability.”

Correlations Change Over Time

But many investors don’t realize correlations aren’t written in stone. “They are moving around constantly,” says Lefkovitz. “The relationship between assets is not stable.”

Stocks and bonds moving together can be good for investors—if both are trending upwards. Looking back, stocks and bonds have moved in the same direction in 18 of the 25 one-year periods since 2000, including 2024 to date.

For 17 of those 18 periods, stock and bond returns were positive. Comparing the returns on the S&P 500 Index and the Bloomberg US Aggregate Bond Index, 2022 was the first time since the inception of the Aggregate Bond Index in 1980 that both stocks and bonds had negative calendar-year returns.

“In the few equity market selloffs before 2022, when equity markets went down, bonds went up,” says Lefkovitz. “That’s why it was such a big surprise when bonds did not go up in 2022 when stocks went down.” During the 2020 pandemic, the 2008 market crash, and the early 2000s dotcom bubble aftermath, bonds went up. “Investors got accustomed to bonds acting as a shock absorber during equity market panics and selloffs,” Lefkovitz explains.

What Should Investors Do?

In his article on the three lessons from recent market drama, Lefkovitz writes, “There is nothing permanent except change.” He explains that in 2022, investors learned that correlations (specifically between stocks and bonds) can and do change.

However, he says diversification still holds merit for investors: “Diversification is always a sensible approach in the face of uncertainty. Portfolios should be ready for a range of scenarios. Because the future rarely resembles the past, the case for holding a broad set of assets is strong.”