February 20, 2024

From 2022 to 2023, the financial markets presented a unique challenge to the widely accepted principle of managing risk through diversification. The traditional 60/40 stock and bond mix had been a cornerstone strategy for mitigating risk since it became popularized in the 1950s. It comes under pressure from time to time when stocks and bonds move in the same direction, and it faced an unusual test when they both headed south.  In 2022, the S&P 500 fell significantly, and contrary to expectations, the bond market also saw a significant decline. This became one of the worst periods on record for both asset classes since the great depression, which tested the meddle of casual and professional investors alike.

The root cause of this atypical market behavior can be traced back to the economic conditions of 2022-2023, particularly the Federal Reserve’s response to soaring inflation rates. The Fed’s decision to significantly raise interest rates had a dual impact, affecting both stocks and bonds negatively.  It affected stocks by crushing profitability, adding to the existing debt services of companies.  It affected bonds by triggering the downward pricing of existing bonds with uncompetitively lower yields.

By the middle of 2023, the situation hadn’t fully resolved. Portfolios with a higher allocation to bonds continued to underperform those with a greater emphasis on stocks.  Conservative investors were wondering if they should abandon their 60/40 for something more aggressive like an 80/20. Such a dilemma involves choosing whether to adjust their risk tolerance in search of potentially higher returns, or to maintain their current strategies, potentially missing out on market growth cycles. This period serves as a reminder that while diversification remains a fundamental principle in investing, its outcomes can vary significantly depending on market conditions. It emphasizes the need to remain adaptable to potential shifts in investment strategies while maintaining a long-term perspective, recognizing that market anomalies do occur.

Despite the challenges faced by the 60/40 strategy in 2022-2023, it still holds value as a foundational approach to balancing risk and return over the long term.  When considering a lifetime of investing, which spans multiple decades (and hence multiple business cycles), we should expect to see situations like these arise. As always, we encourage clients to stay invested, hold the course, and talk to their advisors if their lifestyle needs or liquidity situations change.