Variations on 60/40 portfolios

This is part 2 of a series of posts:

  1. A closer look at common asset classes
  2. Variations on 60/40 portfolios
  3. An active 60/40 portfolio

In the previous article we looked at the characteristics of common asset classes. An often recommended portfolio, is the so-called 60/40 allocation, created from 60% large-cap U.S. stocks, and 40% U.S. bonds. In this article, we will show how these portfolios are constructed, and what we can expect from them.

Asset class recap

Let’s start with a quick recap of the stock market portfolio, represented through Vanguard’s Total Stock Market ETF, VTI, as a proxy:

60 40 VTI bars

While we like the average return, we don’t like how unsteady they come. Even worse, investments in the stock market suffer from deep drawdowns.

Next, we recap the performance of bonds, represented through Vanguard’s Total Bond Market ETF, BND, as a proxy:

60 40 BND bars

As we can see, the bond returns are much more stable. However, on average they are also much lower.

A first attempt

Now, let’s combine these two to a 60/40 portfolio:

60 40 VTI BND

We make the following observations:

  • The average annual return of our portfolio is now 6.1%. That is no worse than the return of the S&P 500, even though we added the lower performing bonds to the mix.
  • The maximum drawdown is significantly reduced to now 34%. Also, the time to recover shortened a lot.
  • The overall beta is now 0.6, which is exactly what we would have expected.

Overall, this is a big improvement, but still not the ultimate answer to our concerns.

Using negative correlations

From the post on asset classes we remember, that TLT, iShares 20+ Year Treasury Bond ETF, has a negative correlation to the stock market. Let’s have a look once more:

60 40 TLT bars

Now let’s try these two in a 60/40 portfolio:

60 40 VTI TLT

We make the following observations:

  • Our return has increased to an annual average of now 7.5%
  • The maximum drawdown has decreased to 30%
  • Beta has decreased to 0.44

While we are still looking for a smoother ride, we have made lots of progress towards a sound investment.

Takeaways

What have we learned from this exercise?

  • By combining common asset classes, we can increase returns, and reduce volatility.
  • When pairing asset classes, it is important to use negative correlations to our advantage.
  • There are limits to how well this will work, as unfortunately there are only few negatively correlated assets available, and those negative correlations are weak.

In the next article, we will show how to further improve the characteristics, by actively managing the portfolio.