This Popular Portfolio Strategy Can Actually Lose You Money
Many long-term investors have championed the 60/40 portfolio, which holds 60% stocks and 40% bonds, as a classic investment strategy that can generate risk-adjusted returns. But Morningstar says persistent inflation and interest rate increases in 2022 have caused investors using this asset allocation to lose more money than if they had invested heavily in stocks. Let’s take a look at why the 60/40 portfolio is hitting all-time lows and what investors can do to protect their money.
A financial advisor can guide you through different asset allocation strategies to adjust your portfolio to inflation and rising interest rates.
Why the 60/40 portfolio is hitting historic lows
The 60/40 portfolio was designed to help investors minimize risk and generate a consistent rate of return over time. This is done by constructing a portfolio that allocates 60% to stocks and 40% to bonds. In doing so, investors take on more risk to take advantage of the higher growth potential of equities and offset that risk with safer investments in bonds.
The basic idea behind this asset allocation is this: while stock and bond markets may go down from time to time, they rarely go down together. But in 2022, Chicago-based financial firm Morningstar says that portfolio strategy has been thrown off balance by persistent inflation and interest rate hikes by the Federal Reserve.
“The result is that even investors whose portfolios are diversified between stocks and bonds – through what is often referred to on Wall Street as the 60/40 portfolio approach – face losses approaching 20% this year. In fact, in the third quarter, the performance of a 60/40 portfolio would have been worse than that of a portfolio simply invested heavily in equities,” Morningstar published in an article.
Shares hit a new bear market low with the asset’s worst performance in 2022 so far – down 24.9%, according to the financial firm. And bonds, meanwhile, “are also having their worst year in modern history”, falling 14.6% over the same period.
In the past, a low correlation between stocks and bonds offered investors an attractive way to diversify portfolios and benefit from the returns of both asset classes. However, persistent inflation and the Federal Reserve’s response to rising interest rates led to a higher correlation between the two investments. And that’s costing many Americans money.
Why stocks and bonds are crashing
Stocks and inflation can have a low correlation, with stock prices falling as inflation rises. And in 2022, Morningstar’s US market index has fallen for three straight quarters, with “losses not seen since 2008”.
Inflation can affect stock prices in three ways:
Businesses have lower profit margins as raw materials, labor and overhead costs increase.
Consumers don’t have as much money to buy the company’s goods and services, which decreases the company’s revenue and net income.
And, when a central bank raises interest rates to control inflation, businesses are reluctant to borrow money because it costs more to take on more debt.
Now, with the highest rate of inflation in four decades, the Federal Reserve raised interest rates three times on May 5, June 15 and July 27. And that, too, drove bond prices down.
Bonds tend to move in the opposite direction to interest rates. So while the Federal Reserve raised interest rates in 2022, many investors who were already seeing stocks tumble in a bear market also failed to find a safe haven in their bond investments.
In the past, investors using the 60/40 asset allocation relied on more conservative bond investments to diversify. But with persistent levels of inflation this year, the relationship between stocks and bonds could continue to reverse as the Federal Reserve raises interest rates.
“I think the monetary policy stance is slightly tight, and we’re starting to see some adjustment to excess demand in interest rate-sensitive sectors like housing. But more needs to be done to reduce inflation. significantly and persistently,” Federal Reserve Governor Christopher said. Waller said in a speech. “I expect additional rate hikes early next year, and will be watching the data carefully to decide the appropriate pace of tightening as we continue to move into more restrictive territory.”
How investors can protect their portfolios
With persistent inflation and interest rate hikes on the horizon, investors may want to adjust their investment style and consider other asset allocations to balance their portfolios.
Here are four common investment strategies:
Look beyond value and growth. Investors often compare value stocks to growth stocks when building a portfolio. But in a volatile market, it can be difficult to choose between one or the other. Morningstar, however, says investors can instead identify other investment opportunities by calculating a stock’s beta or volatility.
Add other inflation hedges. Some investors believe stocks are still reliable hedges because they can historically produce total returns that outpace inflation. Others will keep their savings bonds because they guarantee the amount of your earnings. But you can also consider adding real estate and commodities as inflation hedges to diversify your portfolio.
Combine active and passive investments. Investors are often divided between choosing active funds that aim to beat a stock market or passive funds that just follow it. Although you can also take an intermediate approach and research whether combining active and passive investments can help your portfolio adapt to changing market conditions and capitalize over time.
Minimize your losses with tax-efficient strategies. Investors can help boost their portfolios by using their investment losses to reduce capital gains taxes. This strategy is called tax-loss harvesting and here are two examples to compare how much you can save.
Rising inflation and interest rates have changed the relationship between stocks and bonds in 2022. And while the 60/40 portfolio may still be a preference for some investors, others are considering different investment styles and asset allocations to diversify their portfolios.
Advice to investors during inflation
A financial advisor can help you compare different asset allocation strategies for your investment portfolio needs. SmartAsset’s free tool connects you with up to three financial advisors who serve your area, and you can interview your matching advisors for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.
If you want to know how much your investments can grow over time, SmartAsset’s free investment calculator can help you get an estimate.
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