How Risky Is The 60/40 Portfolio?

The correlation between the 60/40 strategic allocation and the equity market in the last 30 years is close to 0.9. Actually, portfolio risk, as measured by maximum drawdown, has only been low during strong equity market uptrends.

The correlation is shown in the chart below (Source: Portfolio Visualizer)

Correlation of the 60/40 portfolio with stocks is 0.88. This portfolio offers no protection to investors in case of a large stock market correction. The sales pitch about the effectiveness of this strategic allocation is based on the assumption that money will flow from stocks to bonds in bear markets. This assumption is wishful thinking: falling stocks-rising bonds is only one possible scenario depending on prevailing market conditions. The other scenario is falling stocks – falling bonds. This can result in a nightmare for strategic allocations of this form.

Actually, a drawdown of 27% in November 2007 was not far from a nightmare, as shown in the chart below that shows the drawdown profile of the 60/40 portfolio (Source; Portfolio Visualizer)

The table below the chart shows the worst three drawdown levels since 1978. There is no need of advanced statistics: If a 27% drawdown has occurred, a 50% drawdown is also possible although the probability is lower. But the probability is not zero and given enough time it will happen. This will be uncle point for most passive investors because they will have to decide whether moving to 100% cash will be prudent action.

Moral hazard induced purposely by central bank direct intervention in equity markets offers a false sense of security to investors in these trivial portfolios. Diversification is required to minimize probability of uncle point. In a recent article I showed how investing 30% in a currency trend-following system can smooth the 60/40 portfolio equity curve and potentially provide protection during turmoil.

The green line is the equity performance of the 60/40 portfolio, the red line shows the equity performance of a forex strategy and the black line is the 30% forex-70% 60/40 portfolio allocation.

The combination of strategic and tactical allocation is not for everyone. A lot of research must be done and this is a tack for a financial adviser. The transition to tactical or even semi-tactical from strategic is not trivial at all.  However, as equity markets are inflated by policies of central banks driven by political decisions, future risks may be much higher in the future than those encountered in the past.

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Charting and backtesting program: Amibroker


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