As investing in stocks and bonds has been put to the test lately, the traditional 60/40 investment strategy (60% stocks, 40% bonds) is poised for its worst quarterly performance in decades. But we don't necessarily have to completely abandon the old diversification strategy: we just need to adapt it a little.
Why is the stock and bond investment strategy performing so poorly?
Simply put, continuing supply chain issues, coupled with skyrocketing commodity prices, raw materials, raised fears that we are on the verge of a new era of stagflation, that is, low economic growth and high inflation. This combination simultaneously hurts stock and bond investment prices, draining profits from the 60/40 portfolio.
Compounding the problem, the US Federal Reserve, after initially being slow to respond to the highest inflation in 40 years, has begun raising interest rates to their most aggressive level in decades. These higher interest rates are further dragging down investment returns on stocks and bonds.
The stock and bond investment strategy is set for a bad quarter, even worse than during the 2008 global financial crisis. Source: Bloomberg
In total, the 60/40 portfolio has plummeted 14% so far this quarter, according to Bloomberg. It is worse than the performance it recorded in the depths of the global financial crisis or in defeating a once-in-a-century pandemic.
How can you fix your stock and bond investment strategy?
A simple way is to incorporate a trend filter on the two main components of the 60/40 portfolio (stocks and bonds). For example, we may place our stock investment in a particular asset if it is in an uptrend and avoid (or sell) if the trend turns bearish. We can do this using a simple technical indicator, for example, the 12-month price momentum, which measures the percentage change in the asset's price over the previous 12 months. If it is positive, it is an upward trend; if it is negative, it is a bearish trend.
Comparison of returns of different stock investment strategies. Source: Schroders
Here's how these mods work: On the last trading day of the month, we first see if the 12-month price change of the stock market (using some index or ETF) is positive. If so, we invest 60% of the portfolio in stocks. If not, we invest that 60% in cash, earning the current interest rate. Next, we do the same with bonds: we invest 40% of the portfolio in bonds if their 12-month price change is positive. Otherwise, we will invest that part in cash. We then hold everything until the last trading day of the following month and repeat the process.
5-year temporal graph of the LBUSTRUU:IND. Source Bloomberg
How would the stock and bond investment strategy have worked in the past?
We're going to test this stock and bond investing strategy over the past 45 years using data downloaded from Bloomberg. We're going to use the S&P 500 total return for stocks and the total return for Bloomberg US Aggregate Bond Index for Bonds. For cash, we will use the US federal funds effective rate, a good indicator of the return generated in cash. Here are the results:
Investment performance of the classic 60/40 investment strategy versus one with a trend filter.
Measured over the past 45 years, the two versions of the stock and bond investment strategy generated virtually identical average annual returns of nearly 10%. But their risk profiles were very different.
The annualized volatility of the trend-filtered 60/40 strategy was 8% over the same period, significantly lower than the 9,6% of the classic 60/40 strategy. In other words, the 60/40 trend-filtered portfolio generated higher investment returns per unit of risk.
Another important measure for assessing a strategy's risk is maximum drawdown (MDD): the largest peak-to-trough decline in a portfolio's value. Using a trend filter reduced the MDD of the 60/40 portfolio by more than half: it showed a maximum decrease of 17% compared to 37% for the classic version.
Why stick with the stock and bond investment strategy?欄
The 60/40 is a traditional investment strategy that has worked well in the past. But many investors abandon even the best strategies when they start experiencing large losses on their stock and bond investments. That is why it is important to control risk and avoid large losses. Not only does it lead to better investment results, but it also makes you more likely to stick with the strategy.
Historically, incorporating a simple trend filter into the 60/40 portfolio has reduced its volatility and investment drawdowns while keeping profitability intact. And it is likely to achieve similar results, regardless of how we divide our portfolio into different asset classes.