Why the outlook has improved for the 60/40 model

By Lukas Brandl-Cheng, investment strategy analyst, Vanguard Europe

• Multi-asset investors can expect improved long-term returns from their portfolios after the sell-off in global equity and bond markets in 2022.
• Higher interest rates, which played a large part in the sell-off, are also the primary driver behind the improved long-term outlook.
• Lower-risk portfolios with higher relative allocations to global bonds have seen the greatest increase in expected long-term returns.

One of the key features of the sell-off in global equities and bonds in 2022 was the degree to which both asset classes fell together¹.

This breakdown in correlation was disconcerting for many investors and led some to question whether the 60% equity/40% bond portfolio still had merit as an investment strategy.

Our research finds that correlations can move aggressively over shorter time horizons but that it would take long periods of consistently high inflation for long-term correlation measures – those that more meaningfully affect portfolio outcomes – to turn positive².

Meanwhile, our outlook for global equities and bonds has reversed its downward trend of the past decade, illustrated in the chart below through our 10-year annualised return expectations for a 60% equity/40% bond portfolio since 2004. The upward trend to the right of the chart reflects the improved return expectations for multi-asset investors from 2023 until the end of 2032, when the significant falls in equity and bond markets in 2022 are no longer dragging the average 10-year returns down.

This higher return outlook is largely due to the higher interest rates that central banks have implemented to fight inflation, causing the price declines we have seen in both equity and bond markets. These forces have also raised return expectations for the next decade, because yields on developed-market sovereign debt are the foundation on which the returns of risk assets are built.

60/40 portfolio returns are now more in line with our view from 10 years ago

Past performance is not a reliable indicator of future results. Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.

Notes: This chart shows the actual 10-year annualised return of a 60% global equity/40% global bond (hedged) portfolio in EUR compared with the Vanguard Capital Markets Model (VCMM) forecast made 10 years earlier. For example, the March 2014 data at the beginning of the chart show the actual return for the 10-year period between 31 March 2004 and 31 March 2014 (solid line) compared with the 10-year return forecast made on 31 March 2004 (dashed line). After September 2022, the dashed line is extended to show how our forecasts made between 31 December 2012 and 30 September 2022 (ending between 31 December 2022 and 30 September 2032) are evolving. The interquartile range (darker grey shaded area) represents the area between the 25th and 75th percentile of the return distribution and the lighter grey shaded area represents the area between the 5th and 95th percentile. See footnotes for further details on asset classes.

Source: Refinitiv as at 31 October 2022 and Vanguard calculations in EUR, as at 30 September 2022.

IMPORTANT: The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modelled asset class. Simulations are every quarter, between 31 March 2004 and 30 September 2022. Results from the model may vary with each use and over time.

Expected multi-asset portfolio returns now higher

Ultimately, the silver lining to the sell-off in 2022 across equity and fixed income markets is that our long-term return outlook has improved for multi-asset investors.

The upgraded long-term return outlook is most marked within fixed income. When interest rates rise, bonds re-price lower immediately. However, cash flows can then be reinvested at higher rates. Given enough time, the increased income from higher coupon payments will help offset recent price declines and an investor’s total return should increase.

Lower-risk portfolios with higher relative allocations to bond markets have seen the biggest improvement in expected 10-year annualised returns, as shown in the chart below.

The green figures in brackets highlight the improvement, in percentage points (pp), relative to our forecasts from a year ago. Across the risk spectrum, we’ve seen expected returns improve on an annualised basis over the next decade by around 2.5pp.

Expected multi-asset portfolio returns now higher

Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.

Notes: The forecast corresponds to the current distribution of 10,000 VCMM simulations for 10-year annualised nominal returns in EUR for the asset classes highlighted here, and the change relative to last year's median forecast (in parentheses). Asset-class returns do not take into account management fees and expenses, nor do they reflect the effect of taxes. Returns do reflect reinvestment of dividends and capital gains. Indices are unmanaged; therefore, direct investment is not possible. Equity comprises global equity (MSCI AC World Total Return Index Euro). and Ffixed income comprises global bonds (Bloomberg Global Aggregate Index Euro Hedgedhedged). See footnotes for further details on asset classes.

Source: Vanguard calculations in EUR, as at 30 September 2021 and 30 September 2022.

IMPORTANT: The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modelled asset class. Simulations are as at 30 September 2021 and 30 September 2022. Results from the model may vary with each use and over time.

While there may yet be further volatility in 2023, patient multi-asset investors that maintain discipline with a strategic allocation to global equities and bonds are likely to be rewarded over the long- term, in our view. That’s why we think investors should stay the course and maintain a long-term perspective to have the best chance of investment success.

To find out more, read the full Vanguard Economic and Market Outlook for 2023: Beating Back Inflation.

¹ Vanguard calculations in EUR, based on data from Refinitiv, as at 31 October 2022. Global equities represented by the MSCI AC World Total Return Index Euro. Global bonds represented by the Bloomberg Global Aggregate Index Euro Hedged.

² Source: Global Macro Matters: The stock/bond correlation – Increasing amid inflation, but not a regime change. Wu et al. Vanguard Research, 2021.

VCMM – benchmarks used for asset classes

• Global bonds (hedged): Bloomberg Global Aggregate Index Euro Hedged.
• Global equity: MSCI AC World Total Return Index Euro.